You Need to Be an Elite Advisor Using Simple, Efficient Investment Portfolios

By iSectors Chief Investment Officer, Chuck Self on April 29, 2018

Contributed by Chuck Self, Chief Investment Officer, iSectors

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Many financial advisors are attracted to the industry due to their love of markets (especially stock markets). Others get a thrill from helping others improve their financial lives. Whatever the reason, these professionals quickly find that a profitable business is dependent on spending a significant amount of time on client servicing and marketing.

The chart below presents the results of a study clocking the hours spend by elite and non-elite advisors. There is a clear differential in how elite and average advisors spend their time. The average advisor spends over 40% of their working hours on investment and administration matters.  Client-based and employee training activities constitute most of elite advisors’ working hours.

Source: Advisor Benchmarking Inc., Practice Made More Perfect,
Mark Tibergien and Rebecca Pomering, Bloomberg Press 2011

The difference between advisors with $50 million of assets under management and those with $500+ million is the time spent on investment management compared to client service and acquisition.  If an advisor wishes to become elite, (s)he must choose to take one or more of the following actions:

  1. Hire an investment professional to manage the portfolio, research and back office operations.
  2. Significantly simplify the investment management portion of the firm’s processes.
  3. Outsource investment management to a qualified asset allocation specialist.

Simple Portfolios

No matter which action(s) is(are) taken, there is a need to simplify client portfolio management.  Although every client is different, there are often commonalities between them that can help you systematize the investment program offered (“Common Portfolio”).  This not only allows you to spend less time on investment management but eases the preparation for client service and acquisition meetings. Clients and prospects using or needing the common portfolios will receive a clear, rehearsed explanation of their investments.

For most clients, only two strategies are needed:

  • A multiasset allocation with a heavy equity component.
  • A liquid alternative allocation that truly diversifies the multiasset allocation.

Multiasset Allocation

The typical non-elite advisor focuses either on security selection or fund investments.  The security selector will wade through research reports and/or technical studies to create portfolios with the “best stocks.” Portfolio risk analysis is often overlooked in the process.  As Nobel Laureate Harry Markowitz said, “Diversification is the only free lunch in finance.” These clients tend to perform very well or poorly depending on the skill of the advisor and the market environment at the time.  Unfortunately, it is difficult to ascertain either advisor prowess or market direction in advance.

Those advisors managing portfolios with fund investments (mutual funds or exchange-traded funds) are likely to have somewhat diversified portfolios.  But they fall into two camps. The first group invests only in a few of the “best funds,” falling into the trap of the security selectors previously discussed. More often, advisors invest in too many funds that are all highly correlated with each other.  Their clients pay high levels of fund fees to own a (narrow) index fund.

The Morningstar/Russell nine box capitalization/style construction process is an example of unproperly diversifying portfolios. Advisors utilizing this practice invests client portfolios in each of six equity funds: large growth, large value, midcap growth, midcap value, small growth, and small value. By covering the market of the top 3000 to 5000 stocks, they believe they have created strongly diversified portfolios.

As the chart below indicates, the cap/style boxes have become highly correlated over the past few years.  Even though the portfolio may have six funds, there is very little diversification in the account. They will all move together, especially in down markets.

Source: Morningstar, iSectors

How is a comprehensively diversified, multiasset allocation created? Of course, the individual securities’ returns should, at worst, be moderately correlated or, better yet, uncorrelated to each other.  Also, these portfolios vary exposure to equities based on expected levels of risk and return.  To do this, these strategies use 21st century statistical and computational methods to create expectations that outperform intuitive or qualitative assessments of the environment.  The strategy must utilize many factors as inputs to compute the expectations. Finally, the model should focus on reducing downside risk instead of outperforming an index.  For the most part, clients can accept some underperformance if the absolute returns are quite positive.  They will not be happy if returns are significantly negative even if the results bested a benchmark (as many advisors experienced in 2007 – 2009).

Liquid Alternative Allocation

Including a multiasset allocation in a client’s portfolio is not enough.  As we experienced in the first quarter of 2018, US stocks and bonds can both earn negative returns at the same time.  The quantitative indicators show that this may continue.

For example, the chart below indicates that stocks, bonds and real estate are all currently overpriced. The only other time this has taken place in the last 35 years was in front of the 2007 to 2009 market debacle.  Almost every investor is under-diversified given the current risk/return expectations among traditional assets.  It is imperative that advisors further diversify client portfolios with liquid alternatives.

Liquid alternative asset classes include:

  • Precious metals bullion and equities
  • Physical commodity and commodity equities
  • Hedged strategies
  • Alternative private-like equities
  • Alternative fixed income including inflation-protected securities
  • Emerging market equity and fixed income
  • Currencies

With the advent of exchange-traded funds (ETFs), it has become much easier to invest in these asset classes.  Advisors should be careful of two tax traps while investing in liquid alternatives ETFs:

  • Many of these ETFs are taxed as partnerships and issue K-1s; Funds to be purchased should issue 1099s at year-end.
  • ETFs taxed as “collectibles” do not receive favorable long-term capital gain treatment with a maximum 20% tax rate; Long-term gains are taxed at the investor’s ordinary tax rate with a cap at 28%. Funds taxed as collectibles should be avoided.

Work performed by BlackRock indicates that the optimal account proportion to be allocated to liquid alternatives is 15%.  When added to a balanced portfolio, 10% should come from equities and 5% from fixed income. Given the complexity of these asset classes and the correlations to each other, it is best for most advisors to hire a specialty asset allocation firm to manage these portfolios.

iSectors® Multiasset and Liquid Alternative Solutions

As a full-service asset allocation firm specializing in helping financial advisors to become elite, iSectors offers both multiasset and liquid alternative solutions.

On the multiasset side, the iSectors Post-MPT Moderate Allocation seeks investment returns that outperform a 60-40 stock-bond index (as measured by 60% S&P 500 stock market index + 40% Barclays Aggregate Bond Index) with lower downside risk over a complete market cycle. iSectors objectively allocates and rebalances the portfolio among up to 9 specific, low-correlated asset classes (as shown below.) The mathematical process is guided by a series of economic and capital market factors. Over the past five years, it has outperformed the median US Balanced strategy by over 200 basis points on an annualized basis according to the Morningstar ETF Managed Portfolio database (as of 12/31/2017).

Source: Standard & Poor’s, iSectors

 

For aggressive clients, the iSectors Post-MPT Growth Allocation’s goal is to achieve investment returns that outperform the Standard & Poor’s 500 stock market index with lower downside risk over a complete market cycle. The portfolio manager objectively allocates and rebalances the portfolio among up to the same 9 specific, low-correlated asset classes as iSectors Post-MPT Moderate. The mathematical process is also guided by a series of economic and capital market factors. Over its 13-year life, the strategy has realized less than one-half of the declines experienced in the US equity markets.

On the liquid alternative side, advisors should consider the iSectors Liquid Alternatives Allocation. This model embraces the philosophy pursued by the managers of endowment portfolios at institutions like Yale and Harvard, by allocating to alternative investments such as hedge funds, alternative private equity, alternative fixed income, and real assets.  The strategy invests in alternative investments that are available either through an ETF, mutual fund, closed-end fund, or an SEC registered private fund (the model does not hold unregistered securities or private partnerships). Because the holdings in the portfolio are registered, liquid securities, iSectors Liquid Alternatives Allocation offers investors several unique advantages: low minimum investment, no lockup or minimum holding period, daily liquidity, no performance fees, and, investors are not required to be accredited.  The model seeks to use alternative investments to provide a better return and reduce volatility and portfolio drawdown when compared to a representative index of alternative investment strategies, (measured by the HFRX Global Hedge Fund Index) over a complete market cycle. Over the past five years, it has outperformed both the median Morningstar Global Alternatives strategy and the HFRX Index.

For advisers worried about a rise in inflation, the iSectors Inflation Protection Allocation strategic model holds a diversified portfolio of securities that historically have been resistant to inflationary pressures. Security holdings within the model may include precious metals (including gold & silver), real estate, commodities, (including timber, agriculture & energy), emerging market stocks and bonds, and inflation-protected bonds. The strategy is up over 20% since the beginning of 2016 while providing low correlation to equity and fixed income markets.

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If you are a financial advisor that wishes to learn more about effective methods to simplifying your investment management processes, please contact Scott Jones at 800-869-5184 or [email protected].  Alternatively, if you have not already done so, you can register here, on our website, to review information on the iSectors Allocations described above.

Individual investors can contact Scott Jones for a referral to a recommended iSectors advisor that can help them determine the best iSectors asset allocation for their portfolios.

Performance Disclosure

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