In our recent article, we discussed why as an advisor, you need a clear investment philosophy, the benefits it can provide, and how it allows you to have more meaningful conversations with your clients – at any stage of the market cycle.
As a financial advisor, your investment philosophy serves as a reference point to guiding your decision-making process and ultimately provides your clients peace of mind knowing their advisor has a firm decision-making process when allocating capital.
Investment philosophies are typically created at a practice-wide level and are then tailored to each client based on their specific financial goals, risk tolerance, and situation.
You should also take into consideration your clients’ investment time frame, financial goals and current market conditions. By having a documented investment philosophy, you’re able to provide a consistent and reliable approach to investing tailored to each individual client.
Your investment philosophy should focus not only on the goal of maximising the potential of your client’s portfolio but also on ensuring your client has the ability to sleep soundly at night, knowing their investments are being managed with utmost care.
Constructing your investment philosophy
When constructing portfolios for clients, the typical advisor will fall into either a passive, active or a core-satellite-based philosophy. However, the process of determining which funds should go into a client’s or advisor’s portfolio appears to be poorly understood on occasion.
It is common knowledge diversification can help to reduce risk within a portfolio and support clients in achieving their long-term goals. This may not occur by using eight different fund managers or investment solutions, as managers will often have similar holdings, and there is no significant diversification benefit as a result.
For example, during the heyday of WAAAX shares (Wisetech, Appen, Altium, Afterpay and Xero), it was common to see many growth-focused managers all holding large allocations to these securities. In fact, by investing with managers that have similar holdings, an investor would not see any substantial rise in the portfolio diversification, and for the advisor, it would merely add additional reports/updates to be regularly read.
At a broad level, the investment philosophy of the best investment firms typically falls into the following categories:
1. Value – looking to unearth and own assets that trade below their worth. Typically, it will be defined by low price-to-book and price-to-earnings ratios. This is the traditional Benjamin Graham school of investing.
2. Quality – looking to own assets of superior quality. Typically, this involves looking for high returns on invested capital, a strong balance sheet and a history of strong performance throughout economic cycles. This is the Warren Buffett approach (credit must be given to Charlie Munger for converting Buffett from a value investor to a quality investor).
3. Growth – looking to own assets that will grow significantly faster than the economy and market as a whole. Often these will be in emerging companies where there are limited profits to be seen today. Still, an investor in this style of investments is not focused on the past but instead on the future potential of earnings streams. Peter Lynch is arguably the most famous example of this style.
4. Hybrid –this involves utilising a mixture of the above.
5. Passive – simply holding a vast index of investments (often the ‘the good, the bad and the ugly’) and allowing the investments to be rebalanced according to the underlying index. While these started as very simple index trackers, recently, there has been a surge of “smart beta” and “factor” based passive vehicles released.
Selecting investment funds to suit your philosophy
When building a diversified portfolio for your clients, it is important to ask the following questions:
1. What is the fee structure of the investment?
2. What is the alignment of the investment managers with the end investors?
3. What is the investment manager’s style and do the holdings reflect this? Often when markets move, one style outperforms and underperforming managers may chase returns by drifting to the hot theme of the day.
4. Are there significant investors in the fund, or is it a diversified client base? If a manager has a large percentage of their assets from a single mandate (which is particularly important in less liquid strategies), then should this mandate get pulled, it can create significant short-term losses for clients and the viability of the manager may be in question.
5. How does this investment complement other investments in your client’s portfolio? For example, there would be little advantage in holding five different ASX 200 ETFs or five international equity managers that hold the same assets.
6. What do your clients require? Retired clients are generally more income-focused, more concerned about volatility and there is love amongst retirees for franking credits. During retirement, there are a range of issues for advisors and their clients to consider including; longevity risk, macroeconomic risks (rising or declining interest rates), prolonged periods of elevated inflation, sequencing risk, changing legislation and with our aging population, the risk, of outliving retirement savings.
7. Does this proposed investment offer something unique to your clients that they cannot get for themselves? As markets demonstrated during covid, often during periods of peak fear, companies will do special issues only available to institutional holders.
8. What is the track record? As clients are told numerous times, past performance is no indicator of future performance. Still, due diligence on a manager will reveal the manager’s investment processes, history of staying true to style, mistakes, successes, and potentially long-term performance.
9. How does the manager communicate? Do they give relevant, insightful and thorough performance updates, or are they simply one-pagers with performance figures? Often the more detailed and timely the communication, the easier it is to explain to clients.
10. When interviewing a manager, everyone likes to talk about their big wins, but a more revealing question set is “Tell me what happened with your biggest detractor?” followed by “What changes have you made to your processes to ensure it doesn’t happen again?”.
Creating and implementing an investment philosophy not only enables you to deliver a clear message to your clients about how their money is invested but often creates further efficiencies within your advice practice.
Finding a financial advisor to trust with their retirement savings and future is an enormous decision for clients. Having a clear and well-articulated investment philosophy enables you as an advisor to reassure prospective clients they will be in safe hands, invested appropriately for their long-term needs, and assists in the conversion of first appointments to long-term clients.
Asking these questions will help you evaluate your investment philosophy and ensure you select the right funds to be part of your philosophy. This can help you make more informed decisions and tailor more well-diversified investment portfolios for your clients.
Schroders has launched an investment education space on the Ensombl platform to give advisors a safe space to expand their investment knowledge to have more influential conversations with clients. Join the space here
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