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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

albion

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

albion

• 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):  timhale@albionstrategic.com(W):  www.albionstrategic.com