Market Uncertainty and Diverse Investor Needs: The Three Mandate Approach
When confronting risk, advisors face a challenging environment in 2015: Global equity markets are soaring, while many fixed income markets face the prospect of rising rates and central bank intervention. Meanwhile, the market shocks of 2000 and 2008 loom large in investors’ memories.
Amid this uncertainty, investors now seem to come in two distinct types. Those who feel a need to catch up are pushing advisors for more performance, while those who have been twice burned in the past 15 years are now waiting for the other to shoe to drop before adding risk.
Meanwhile, individual asset class modeling, having now failed in both of the most recent market disruptions, appears to provide insufficient preparation for future downside volatility. We believe that there is room for improvement both in the analysis of more active strategies and in their implementation. We propose a three mandate approach to portfolio construction that seeks to optimize risk allocation while responding to increasingly divergent client needs.
The components of the three mandate approach are as follows.
Exposure to assets with similar risk-reward profiles to broad U.S. stock indices has an important place in many client portfolios. We suggest that most clients benefit by isolating their strategic beta into a separate sleeve. This process allows for advisors and clients to have an agreed upon component of the model that will provide access to consistent market movement, both good and bad, and will serve as the baseline for expectations for other parts of the model.
In response to client demands and an uncertain market environment, some advisors have lately focused on strategies that (allegedly) worked well in 2008, hoping that a single tactical strategy will work again in a similar market environment. We believe that advisors should dedicate a sleeve to tactical beta. We view tactical strategies as risk modifiers or even return seekers, but in our view they are often inappropriate as core strategies. Too often when allocating to tactical managers as core holdings, advisors have run the risk of underperforming the broader market, a circumstance that can become difficult to explain to clients.
Lastly, especially in the current fixed income environment, most client models should contain “diversifier” strategies that have little or no correlation to sleeves one or two. This is a replication of pension plan investing through inclusion of non-correlated funds and strategies and provides an attractive way to manage risk. Whether these strategies are tactical fixed income or more classic alternatives such as managed futures or arbitrage, it is critically important to separate; appropriately benchmark and effectively risk score these holdings.
Serious challenges arise in quantifying the risk profile of diversifiers. Whether they are liquid alternatives or tactical fixed income, many such vehicles have short track records and by their nature have very fluid and inconsistent holdings.
Also, as stock markets rise, pundits are criticizing these types of strategies although they were calling for them in 2009. It takes an increased level of diligence to sort out the opportunities from the pretenders, but while some throw in the towel and look to index (CalPERS), we find considerable talent available and much to be excited about in this particular area of the business. Clear communication with clients about the risks and benefits of an alternative strategy, as well as setting appropriate expectations, is paramount.
Risk Measurement and Implementation
As the question of appropriate risk for each client becomes more complicated, advisors are demanding new approaches. One potential answer, risk budgeting, bases portfolio construction on a target risk level that both advisor and client understand. In theory, risk budgeting improves transparency and works to set appropriate client expectations. However, many advisors lack the tools to appropriately communicate the process to clients.
We believe a suitable investment process starts by quantifying a risk profile that matches client objectives. Using quantitative tools, the advisor can clearly show how each piece of a portfolio contributes to overall risk.
The evolved risk budgeting process incorporates one additional component: advisor and client determine which managers will be most effective in a variety of market conditions: Unpredictability of market cycles demands the use of multiple investment teams with diverse skill sets. This is not asset class diversification, but a more advanced process in which a client’s risk budget is spread across multiple strategists with different mandates. To successfully follow allocate and implement the three mandate strategies described above, client and advisor must have tools that effectively measure portfolio risk.
Furthermore, implementation of this risk allocation technique requires:
Advanced risk scoring methodology
Access to multiple types of strategies on single trading platform
Increased focus on due diligence for tactical and diversifying investments
Simplified custody options
Strategy level custom reporting for client/advisor communication
With these tools, advisors can deploy a model framework that can effectively communicate appropriate risk targets to clients and then allocate across distinct strategies according to individual needs. This framework helps to alleviate difficulties arising from highly varied investor preferences. The return-focused client looking to recoup previous losses and the risk-averse investor concerned with short-term drawdowns can both find appropriate allocations by using risk budgeting and a three mandate approach.
Over the next few months FTJ FundChoice will be delivering on the above vision. We think that the current challenging market environment and high variability of investment needs indicate that it is time to broaden our spectrum and increase the scope of our services. As always we will be focused on helping our advisors provide the most advanced platform with true open architecture and great value.
The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this commentary is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. FTJ FundChoice does not guarantee any minimum level of investment performance or success of any index portfolio or investment strategy. Past performance is not indicative of future results. Indices are unmanaged and their returns assume reinvestment of dividends and do not reflect any fees or expenses. It is not possible to invest directly in an index. Information obtained from third party sources are believed to be reliable but not guaranteed. FTJ FundChoice makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.