Read our article in the Cayman Financial Review Magazine, eversion 

I recently participated in an investment panel as part of the 2011 Cayman Captive Forum. The intent was to give the owners of captive insurance companies an insight into the factors they ought to be considering in establishing and monitoring an investment programme for their company.  

While some of the advice given was specific to captives, much has a good deal of relevance for the individual investor – indeed even the specific considerations of captives can be adapted to a private client setting.

Here I will set out some of the factors that investors should likely consider when establishing and maintaining their own investment programme.


1. Discovery

Much attention is usually given to selection of investments but sometimes the investment discovery process is overlooked. It is pretty clear that if you start out on the wrong path you will likely end up in the wrong place. That is why it is so important to understand at the outset what kind of investment programme is best for you.

The options range from one where you have full control over all the decisions (execution-only), to an arrangement where you work with an expert advisor but make the final decisions yourself (advisory), to a situation where you hand over day-to-day management of your investments to a professional within defined parameters (discretionary).

Which one works best for you will depend upon factors such as your investment philosophy, your view of the market and other more specific factors such as taxation and control considerations.

Sometimes clients will settle on a combination of the various approaches for different portions of their investment portfolio. This may be done in an effort to capture both strategic and tactical approaches to investing or again for other more specific reasons.

While some clients will make such decisions on their own and approach an investment professional with a defined idea of their needs, most often the right approach will be developed as a consequence of an open discussion around the client’s current investments and their investing experience.

Such a discussion should then move on to consider factors such as return expectations, risk appetite, risk tolerance and investment time horizon. The aim should be to take a holistic view of the client’s investment needs.

This should likely encompass not just the assets under consideration for investing but also investments held elsewhere. With this knowledge it should then be possible to structure an investment solution that meets the client’s investment objectives and risk preferences.

The chart below shows the range of factors that should likely be considered and the impact these will have on the decision as to where the client should lie in the range from a cautious to a progressive portfolio. (See Chart 1)

Chart 1

 

Source: RBC Wealth Management


2. Setting the parameters

Once the work has been done on better understanding the needs of the client, decisions need to be taken on asset allocation and portfolio construction. In other words, how can we structure investment solutions that meet the client’s needs in terms of return expectations, risk appetite and risk tolerance?

Investment theory tells us that asset allocation has a very important role to play in achieving both total return expectations and risk mitigation. The chart below illustrates the risk-return trade-off that occurs when additional asset classes are added to an investment portfolio.

Over the longer-term, modern portfolio theory suggests that by adding additional asset classes it is possible to increase expected return from a portfolio with a commensurate increase in risk.

Indeed, it suggests that by adding relatively small amounts of additional asset classes, clients may be able to increase expected return for the same or lower risk. Over the longer term, it has been demonstrated that this is true when adding both equities and alternatives to a traditional fixed income portfolio.

Depending on the client’s preferences, the most appropriate approach will likely be to develop a strategic asset allocation framework for the investment portfolio and then seek to adhere to it for the duration of the investment time horizon determined during the discovery phase.

The benefit of such an approach is that it takes some of the emotion out of the investment process. In extremely volatile markets such as those we have seen for the past several years, clients will sometimes attempt to time the market or make snap decisions to shift asset allocation in response to a major market event.

Unfortunately, over the long term incorrect market timing decisions may lead to clients missing out on excess returns. Similarly, tactical asset allocation decisions in response to specific news flow can sometimes take place after the market has already moved.

For those clients who wish to be more tactical in their approach, consideration should be given to allocating a portion of their assets to a dynamic strategy while retaining core positions in a strategic approach.

This “core plus satellite” approach can add value in more volatile market conditions and may also meet the needs of those clients who want a portfolio that is more adaptive to market conditions throughout the cycle.  (See Chart 2)


Chart 2: 

The following graphic illustrates the tradeoff all investors face when trying to find the right between risk and risk.

• Lower risk strategies provide security of capital, but may not meet your return objectives.
• Higher risk strategies provide higher expected return or income, but may exceed your willingness to accept investment risk.

Shorter Investment Horizon Lower Expected Return Lower		Risk (Standard Deviation)		Longer Investment Horizon Higher Expected return Higher Volatility Greater Risk of Capital

Determining your optimal portfolio involves balancing three competing priorities:

1. The need to preserve capital and protect your initial investment
2. The need to generate regular income from your investments
3. The need to grow your investment capital over time

Source: RBC Wealth Management


3. Structuring the investment solution

So now you are at the point where you have a thorough understanding of the investment approach you would like to take and you know the various asset classes you would like to use to achieve this.

The challenge then becomes: how do you select investment solutions that fit into this framework? All too often, this is left somewhat to chance. Clients may opt for the in-house solution provided by their broker or bank without understanding how this was arrived at or what other alternatives are available to them.

Or they might rely on personal recommendations from friends or work colleagues as to what solutions have been successful for them. While either of these routes might bring investing success, what is possibly more appropriate is a structured and disciplined approach to selecting the right investment solutions.

Such an approach should likely focus not just on investment performance or cost of the investment vehicles under consideration, but a host of other factors too. The graphic below shows the range of factors that we consider when selecting an investment manager for our platform.

When looking at performance, the emphasis should be on risk-adjusted performance. Unless you are striving for a high-volatility absolute return portfolio, some attention should be given to the risk that is assumed in achieving stated returns and the performance of the solution during times of extreme volatility.

Tied to this, the philosophy, processes, policies and procedures of the manager under consideration should be reviewed thoroughly to ensure that they are transparent and include adequate risk-management safeguards.

The final group of factors to consider should take a look at the human side of the equation, focusing on the education, experience and track record of the investment managers, the way that they partner both with the client and any intermediaries and lastly their attitude toward private client investors. (See Chart 3)


Chart 3

   

                                  Source: RBC Wealth Management

It goes without saying that this is a pretty extensive screening process. When you consider the multitude of funds available to invest in, such an exercise would be onerous to say the least for most individual investors.

This is where some of the value-added should come through in terms of engaging an investment professional. A skilled investment advisor should be able to provide much of the heavy lifting in terms of screening potential funds for these factors and providing recommendations as to which are worthy of consideration.

For a discretionary relationship they should be able to make the decisions on manager appointment subject to the parameters established earlier on in the process.


4. Ongoing monitoring

Once the portfolio is established, the focus should then shift to monitoring and maintenance of the investment programme. Again, most clients will look to their investment professional to either provide this service or at least assist with it.

In a private client context, clients should be receiving investment reports at least quarterly and ideally these should at a minimum provide a statement of holdings, current valuations versus purchase cost and performance versus an established benchmark for both the overall portfolio and the individual asset classes.

In addition, the investment manager should be able to provide commentary and analysis on performance of the individual investment solutions held and either recommendations for any changes necessary for an advisory account or details of changes implemented for a discretionary programme.

If we recognise that the strategic asset allocation is unlikely to change very much during the established time horizon (unless external factors come into play), much of the focus at this stage should likely be on the individual investment solutions that are held within each asset class.

In terms of manager monitoring, many of the items identified as being important during the manager selection process are equally as important for ongoing monitoring. Some of the key considerations in manager monitoring that might necessitate a change of manager could be:
a.    Persistent non-adherence to mandate or professed style
b.    Significant business or organisational change
c.    Underperformance not reasonably attributable to market conditions and/or style bias
d.    Failure to provide satisfactory communication


5. Summing it all up

Hopefully this article has given some insight into the concepts and considerations that should be reviewed in establishing and monitoring an investment portfolio. What should be clear from this is that many clients have neither the time nor the experience to carry out these processes on their own.

For this reason alone, it is certainly worth giving consideration to engaging an experienced investment professional to help navigate through the process. While there may be some additional costs involved in doing so, the potential value-added that a trusted investment professional can bring to bear can be considerable over the long term.

The views expressed are the opinions of the writer and may differ from the views of Royal Bank of Canada.