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Session four:Simple but not easy – the challenges of building a robust investment process
Tim Hale
Albion Strategic Consulting
albion
Simple but not easy The challenges of building a robust investment process
IFP Maximising your assets for business success
CONFIDENTIAL © Copyright Albion Strategic Consulting 2011. All rights reserved.
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albionSimple at its simplest
Owner of global
capitalism
Lender to high quality
borrowers(with inflation
promise)
?
albionWhere it gets tricky
Complexity Uncertainty
Emotions
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albionThe purpose of process
Ambiguity
1
2
3
Alternate futures
?A range of futures
Clear future
3
Source: McKinsey
albionThe value of process
18% ‐13%
2‐4X 6‐>10X
9
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albionOur starting point
• Put on a different hat
Risk manager
Performance manager
albionRobust thinking and common sense
Intellectual sloppiness
Intellectual robustness
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albionNo 'right' answers – just better solutions
Common perception
e.g. Active Passive
Reality
albionElements of the investment process
Your investment philosophyYour investment philosophy
Choosing a suitable portfolioChoosing a suitable portfolio
Portfolio construction processPortfolio construction process
Risk‐controlled implementationRisk‐controlled implementation
Ongoing governanceOngoing governance
pp
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albionInvestment philosophy
• Your investment compass
Your investment philosophy
Financial markets in practice Theory and evidence
Set of coherent and complimentary beliefs
ReturnReturnRisk
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EMH
Market beliefs
Markets work
1 2 3
Markets sort of work Markets don‘t work
PASSIVE The hunt for alpha
Process implication?
Better info Better use
Process implication?
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albionInvestment philosophy summary
• Your investment philosophy checklist
Belief Theory & evidence Process implication
11.
2.
3.
4.
5.
6.
7.
albionOne approach
• Based on a coherent and complimentary set of beliefs
Capitalism
Albion’s beliefs
pworks
Markets work well enough
Ri k dDi if
Costs of all kinds really matter
Risk and return are linked
Diversify broadly
Portfolio structure dominates
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albionAlignment with your governance budget
• Aligning the governance budget to the investment process is critical
Governance budget(Your firm’s capabilities)
Expected return
Risk budget(client related)
Risk
albionDefining the asset class menu
Portfolio construction (risk selection)
Criteria Menu (On/Off) Assumptions
RDRUCISHedge Funds Structured ProductsRegulated
INDEPENDENT?
Competence
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albionSelection criteria
Return source Contribution
Insight (data) Access
Compensation Attributes
albionMaking asset class assumptions
Wise use of historic data
Common‐sense
Simple forecasting
Reversion tothe mean
ConservativeYour
assumptionshistoric data senseguides
the mean assumptions
%
%
%
%%
%
%
%
%
Default premium
Maturity premium
Risk‐Free Rate
Inflation Risk‐Free Rate
Dev. ERP Emerg. RP Value RP Small RP
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albionBuilding robust portfolios for clients
Portfolio construction
Criteria Menu (On/Off) Assumptions
Portfolio construction: theory, rules, testing
Defensive mix Growth mix
Asset class level – model portfolios
ESSENTIAL RISKRDR COP‐OUT?
ESSENTIAL RISKMANAGEMENT TOOL!
albionConstruction approach
Return
Growth • Core return engine. • Widely diversified.
Client portfolios• An appropriate balance between Growth and Defensive assets.
Risk
Defensive • Dampener of Growth returns
assets.• Choices along the risk/return spectrum
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albion
Decision 1:
Developedmarket exposureUK Non‐UK (developed)
No implicit decisions allowed
Decision 2:
Emerging market exposureDeveloped Emerging
Decision 3:
Value & small cap tiltsBroad market Tilted
Decision 4:
Non‐equity exposureEquity only Property
Decision 5:
Non ‐£ currency exposureHedged Unhedged
albionBuilding the growth mix
InternationalInternational
ComfortAllocation Comfort Allocation
UKInternational developedInternational developed
Global developedEmerging economiesEmerging economies
Market ValueValue
Market SmallSmall
Non‐equityNon‐equityEquity
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albionBuilding the defensive mix
Emotional tolerance forConcerns:Concerns:Emotional tolerance for
risk increasing‐ volatility‐ inflation
Concerns:‐ equity market risk
Allocation to equities
Role of fixed income:Low volatilityProtection from inflation
Type of fixed income:
Role of fixed income:Maximum defence against
it k t tType of fixed income:Short‐dated bondsIndex linked gilts
equity market extremes
Type of fixed income:Highest quality = gilts
Longer duration
albionBuilding the defensive mix
• The defensive portfolio
Short termShort term
ComfortAllocation Comfort Allocation
CashShort‐term bonds
Short‐term bonds
Short‐term bonds
Long‐term bondsLong‐term bonds
UK government issued
Non‐UK Government (£)
Non‐UK Government (£)
Government credit risk
Corporate creditCorporate credit
Index linked giltIndex linked giltConventional gilt
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albionSelecting a suitable portfolio for a client
• Willing and able to take risk
Choosing a suitable portfoliog p
Client risk profiling Personal testing
Trade‐off resolution and suitability documentation
COBS 9.2.2.R.
FSA (2011), Assessing
Capacity
RDR
AVOID PORTFOLIOsuitability: Establishing the risk
a customer is willing and able to take and making
a suitable investment selection’
RDR PORTFOLIOPICKING
albionRisk assessment is a conversation
How much investment risk can you tolerate?
1. Risk profiling
Client goals, lifestyle costs, and asset base.
Understand and agree the level of risk you are willing
and able to take2. Financial planning
3. Broad discussion with your client
“Willing”
“Need”
How much investment risk do you need to take?
What is your financial capacity to handle losses?
“Able”
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albionOngoing risk management
Risk‐controlled implementation
Transitioning clients Rebalancing portfolios
Product due diligence
RDR DO IT!
FSA Handbook COBS 6.2A.3 R
‘The new standards for RDR DO IT!independent advice will also require greater
supervisory focus on the criteria that advisers use to select products’.
albion
The Wallet JournalBanco
SantanderPioneer
HSBC
What's the link?
Major institutional money managers cock-up their due diligence (again)!What on earth were they thinking?
ABCDE 13/07/2009xxxxxx 888888 Nr.000000
Quite amazingly a large number ofseemingly sophisticated institutionalinvestors have been duped by Madoffinto investing in his fund that nowappears to be the largets Ponzi scheme
Dexia
BNP ParibasRBC Unicredit
Nomura Holdings
Societe Generale
Man Group
pp gin financial history. “I really can’tbelieve how gullible they must all be tofall for one of the oldest trick in thebook. Whatsort of due dilignce mustthey have performed. Why did bellsnot ring when some major fundsdeclined to invest. Surely someonemust have known what was up other
Nordia RBS
Sumitomo Life
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albionThe due diligence process
It is NOT• Tactical
It is• Strategic.
• Box checking
• Selecting
• Information gathering
• Cursory
• Filed away
• One‐off
g
• Risk avoidance
• Hard work
• Ongoing
• Structured
• Insightful
CYA Risk Management
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• Passive OEICs/ETFs
People• Firm, not people• Reputation• History• Commitment to passive
Performance• Cash replication method• (SWAP based)
• Counterparty analysis• Risk factor exposure
The due diligence process
Performance People• Commitment to passive• Financial stability
Operations• Reputation• Roles• Check out parties involved:
• ACD• Depositary/custodian
R i & d i i
Structure• Pricing/TER• Securities lending program
• Counterparty• Collateral management• Strategy
• Risk factor exposure• Regression analysis
• Trading strategy• Tracking error history ‐ index• TER • Fund turnover• Fund size, flows, concentration
• Registrar & administrator• Regulator
• Understand fund & instruction flows
• Revenue share• Tax/distribution status• Domicile• SWAP counterparty risks• Collateral programme
OperationsStructure
Governance budget
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albionThe governance framework
• Regular, disciplined, focused
Board
Executive
Strategy/oversight Implementation
Follow‐up Roles
AccountabilitiesAgendas Reporting
albionProcess audit
• How close are you?
1. Comfortable with your defined investment philosophy
2. Identified a clear decision pathway that leads to portfolio holdings
3. Process focused on risk allocation
4. Asset class menu clearly defined
5. Portfolio construction approach defined
6. Portfolios are robust, tested and understood
7. Suitability process robust
8. Detailed due diligence in place for fund selection
9. Ongoing risk management and governance process in place
10. Thoroughly documented process plus client storyboard/education
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albionImportant notes
• Albion, authorisation and your obligations
– Albion is not authorised by the FSA to provide advice or to make arrangements ininvestments (or carry out any other regulated activity) and the provision of any servicesby Albion in this educational presentation should not be construed as carrying on anysuch regulated activity.
Tim HaleManaging DirectorAlbion Strategic Consulting5 Charlotte MewsExeterEX2 4HA
( )(T): +44 1392 494141(M): + 44 7974 253604
(E): [email protected](W): www.albionstrategic.com