BEST PRACTICES: PRINCIPLES FOR ALIGNED INVESTMENT ADVICE
After investing capital on behalf of families for a long time, we have seen market ups and downs, bubbles and trends. Through it all, there are several fundamental investments principles for prudent investors:
- We are strong believers of following markets indices at low cost, through passive strategies (beta investments). Historically, active managers often fall short of broad market returns.
- Nevertheless, we seek to beat public market returns (alpha) primarily through private, illiquid investments (alpha investments). Be mindful though that not all private investments to be carefully analyzed as they involve generally higher fees and expenses. Also, they might be a misalignment between the manager and the investor.
- We believe investors should pay close attention to portfolio asset allocation as well as the re-allocation
- We think investors should be real about their portfolio, especially with regard to performance – they should make sure they measure returns only after fees and taxes for example. Moreover, they should be interested in knowing the precise types of risks they are taking to get a particular return and be honest with themselves if they can bear a high volatility.
- Make sure the interests of client and adviser are as aligned as possible. In particular, be aware that the adviser’s compensation might be linked sometimes to the adviser’s investment recommendations.
How did we arrive at these guiding principles?
We saw over the last thirty years substantial growth in the financial industry of companies dedicated to active management. For many years, analysts examined data from data gathered from market studies or regulatory filings. Those who had access and a disciplined methodology could make investment decisions that were ahead of the curve, achieving healthier returns, and compensating for their higher fees.
But given the important increase in access to information due to the internet boom as well as greater regulatory disclosures, such competitive advantage was reduced. The spread between the best and worst managers therefore contracted. In parallel, passive investments (such as ETFs – Exchanges Traded Funds that are funds indexed to indices) gained broad popularity over time. These funds brought an opportunity for investors to substantially reduce the costs for their portfolio management, with little or no reduction in returns.
Recent publications have consistently shown that 85 to 90% of active managers are not able to beat their benchmarks or reference index. More importantly, there is evidence that portfolio returns are impacted at least as much by asset allocation and accurate portfolio construction as they are by the selection of specific managers or securities¹. Given these statistics and the substantially higher fees of active managers vs. their passive counterparts, we must ask ourselves: Why do so many investors still entrust their assets to managers who do not achieve their goals consistently and who put their economic interests before their clients?
The main problem lies in the business model of most asset managers. Instead of focusing on meeting investors’ goals, such as: liquidity, necessary cash flow, investment horizon, risk aversion, etc. many investments professionals are also looking at how much compensation they will obtain by managing their clients’ funds.
As mentioned above, historically, the competitive advantage of managers lay in having access to information first. Nowadays, in most public markets, that differentiation does not exist any longer, with the exception of the private markets. Therefore, in recent years and in the near future, the best investment opportunities will likely be in instruments that are neither listed nor easily accessible by the general public. Currently, the access and ability to analyze these options are one of the greatest differentiators between managers. This has been an advantage for sophisticated investors, such as family offices, sovereign wealth funds, or portfolio managers of large universities, who, because they have longer time horizons and are not subject to short-term performance rankings, have been able to invest differently and in most cases, with higher returns.
In the coming years, a combination of illiquid investments and a low-cost, liquid investments, may well offer investors a better chance of achieving higher overall portfolio returns than those in public markets, along with greater diversification, efficiency and likely with less volatility.
Finally, one should note that active management must come from the appropriate distribution of assets, meaning an appropriate “asset allocation.” Asset allocation has always been the primary driver of a diversified portfolio’s returns, along with high-value assets in the private market sector and indexing to public markets where great transparency lies. Given the current low interest environment and historically expensive asset prices, investors have to evaluate what will generate value given the risk they are willing to take and the cost related to these assets. Now more than ever, taking into account post-tax returns is essential since the management of profit and losses can be used to offset each other.
In our opinion, it is crucial to have a team that is paid only by the client, that avoids or minimizes any conflicts of interest, and whose business model and culture demonstrate a commitment to act in clients’ best interests. In other words, it is crucial to have advisors who are true fiduciaries.
Our five investment principles follow from these conditions and realities, and provide the basis for what could be called aligned investment advice. We believe implementing these best practices is crucial to families and other investors who wish to preserve and grow their wealth enterprises to endure across generations.
¹See Roger G. Ibbotson and Paul D. Kaplan, “Does Asset Allocation Policy explain 40, 90 or 100 percent of Performance?” (The Financial Analysts Journal, 2000)
Note: This review contains our current opinions and commentary. The views expressed here are subject to change without notice. Our commentary is distributed for informational and educational purposes only and should not be considered as investment advice or an offer of any security or service for sale. Information contained herein has been obtained from sources we believe to be reliable, but we do not guarantee its completeness or accuracy.