CPD: Portfolio governance frameworks

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A significant amount of effort and expertise is required to get to the point of portfolio construction.

Financial advice practices face a myriad of decisions every day. One of the more important decisions is whether to insource or outsource portfolio construction at a financial planning practice level. While on the surface it may seem a reasonably simple binary decision, a significant amount of effort and expertise is required to get to the point of portfolio construction and ongoing portfolio management. This article discusses a range of factors that advice practices would need to consider if they were to insource portfolio construction.

The decision to insource or outsource portfolio construction is an important one. The investment approach taken by your practice will impact your clients and their ability to realise their financial objectives. Whichever route you take, due diligence is required to ensure it’s the best approach for both your business and your clients. If you are considering insourcing portfolio construction and management, there are a number of important considerations.

Investment policy

An investment policy provides the blueprint for how you will manage investments. It would generally describe your investment beliefs (for example, a focus on a particular investment style or approach), establish your long term objectives, and detail the investment processes that will enable you to achieve those objectives. Importantly, your investment policy should inform your clients how and why you invest.

An investment policy could consider issues such as:

  • What type of returns are you targeting?
  • How do you propose to harvest those returns?
  • What risk management approach will you take?
  • How will you execute positions?
  • How will you ensure portfolios remain on track?
  • What expertise will you use?
  • How will you remain accountable to your clients regarding their portfolios?
  • Under what circumstances will you review this investment policy?

The blueprint laid down by the investment policy can be divided into five core components as illustrated in figure one. Each of those components will be examined.

 

 

Consider:

Can you clearly articulate your investment beliefs and how they translate to investment policy?

Have you defined how this investment policy will benefit your clients?

Investment philosophy

An investment philosophy is a set of core investment principles and beliefs that guide a person’s investment decision making processes. Its application in practice is reflected in the way investment portfolios are constructed and managed. Importantly, an investment philosophy needs to be understood by a range of stakeholders, including your clients.

A sound investment philosophy would generally consider the investor’s objectives, likely investment horizon, risk tolerance and capital needs. It might consider other factors – a desire for ‘ethical’ investments or a focus on income generation. A large number of decisions need to be made and clearly expressed when setting an investment philosophy. Some of these decisions might include:

  • Investment universe – traditional, such as equities, bonds and cash, versus alternatives such as real assets or private equity
  • Investment style – growth, value, neutral – and the market conditions that will and won’t suit this approach
  • Active versus passive management
  • Strategic (long term) and tactical (short term) asset allocation
  • The integration of environmental, social and governance (ESG) factors
  • Fees and costs – for example, will a performance fee be charged?
  • Research approach and decision making process
  • Risk management approach.

Without a clear investment philosophy, you risk lacking direction when you need it most – particularly in volatile markets when your investment approach might be challenged.

Most investors who achieve long-term success develop a clearly expressed and well supported investment philosophy and hone it over time – they do not make significant shifts in response changing market conditions, they do not chase returns. Investors do, however, need to be aware of structural shifts that might impact longer term investment outcomes. The changing correlation between equities and bonds is one such structural shift.

Example – the Future Fund’s investment philosophy

We believe that:

  • Portfolios are most efficiently managed as a whole, rather than a collection of sub-portfolios.
  • Focus should be on appropriate exposure to market risk factors because these are a stronger driver of long-term total portfolio risk and return than skill-related risk.
  • A higher expected return per unit risk (investment efficiency) can be obtained from a broadly diversified allocation across different return drivers.
  • Prospective returns and risks vary materially over time in a way that is at least partially observable and hence exploitable. The amount of risk taken should therefore be managed dynamically as conditions change.
  • The management of costs is very important to maximising returns.

Consider:

Is your investment philosophy clear and easy to understand?

Will your investment philosophy provide direction in all market conditions?

Investment strategy and implementation

Your investment strategy will guide your more granular decision making, based on factors such as objectives, risk tolerance and capital needs. Some investment strategies focus on capital growth, whereas others may focus more on capital protection. The investment strategy and process are guided by your investment philosophy.

At this stage, you need to make a range of decisions. These might include:

  • Buying and selling securities – do you use a single broker or a panel for listed securities?
  • Will you invest in unlisted securities?
  • Investment research – outsourced or insourced?
  • Access to information, systems and tools
  • Building in-house investment products versus using externally managed products
  • Implementation and management of compliance processes
  • Investment and operational risk management
  • Portfolio construction approach
  • Alignment of interests and management of conflicts
  • A system for measuring the effectiveness of your investment strategy
  • Tax management
  • The framework for managing governance.

Importantly, an investment strategy should be documented in a way that enables your clients to understand your approach. A well-articulated, transparent strategy will engender trust with your clients and ensure they stick with you, even in the bad times.

A well formulated strategy also gives you something to refer to in challenging markets. Not only will it help you avoid making emotional investment decisions, it can make the client conversation a lot easier too.

Consider:

Do you have the requisite understanding and investment experience to develop and implement a robust investment strategy?

Do you have adequate resources to support the systems, processes and personnel required to develop and implement an investment strategy?

Good governance requires the right people – and time

In the same way you expect investment managers to have investment committees comprised of the best and brightest, clients (and regulators) would expect the same of any firm taking responsibility for portfolio construction. Persistently disappointing returns are often attributable to ineffective investment committees, which in turn may result in ineffective structures and processes.

The role of an investment committees is to provide a decision-making framework. Its responsibilities include setting investment objectives, agreeing on an investment approach and monitoring and oversight of investment decisions. It also includes construction of investment portfolios, risk management and compliance with regulatory guidelines.

An investment committee is generally made up of several people with investment expertise and specialisation, as well as those with operational and governance experience. By way of example, consider the Board of Guardians responsible for deciding how to invest the assets managed by the Future Fund. The Board consists of a Chair and six other members, each selected for their expertise in investing in financial assets, managing investments and corporate governance.

As well as specific expertise, do the people you have identified have the time to contribute to both the investment committee, as well as the day-to-day monitoring and ongoing management of the portfolio/s? Although likely to be more time intensive at establishment, the ongoing management of client portfolios may require an additional number of part or full-time hours; whether employing additional resources to undertake an investment role, or replacing internal resources who will do this, internalising portfolio management will likely add to your business’s head count.

Consider:

Do you have the diversity of knowledge, qualifications and depth of experience in-house, or will you need to bring in external expertise?

Do your internal resources have the time to commit to bringing portfolio management in-house?

Regulatory obligations

The regulatory and compliance burden on advice firms has increased over the past decade. Bringing portfolio management in-house will generally add to the regulatory requirements an advisory practice must fulfil.

In the first instance, additional Australian financial services (AFS) licence obligations will apply, along with compliance with additional Regulatory Guidelines issued by ASIC. For example:

  • RG105 – licensing organisation competence, which ensures Responsible Managers have the appropriate qualifications and experience
  • RG133 – details the roles of companies in relation to holding assets and sets out minimum standards for asset holders
  • RG181 – managing conflicts of interests – of particular relevance for managing and distributing financial products in-house
  • RG259 – risk management systems of responsible entities.

Importantly, you need to ensure you comply with the best interests duty and related obligations, which are contained in Division 2 of Part 7.7A of the Corporations Act 2001 (Cth). Are your internally managed portfolios best placed to meet each client’s needs? The legislation requires advice providers to act in the best interests of their clients (section 961B) and provide appropriate advice (section 961G). Last year’s Royal Commission was littered with examples of advisers and practices which failed to do this.

Although many advice practices have an in-house compliance resource, investment compliance is quite different to that associated with providing advice; you would need to ensure your resources have the time and skills to perform both roles.

Consider:

Do you have the time and expertise to monitor compliance with the applicable ASIC requirements and legislation?

Bringing portfolio construction and management in-house can provide you with several benefits. It can be a way to differentiate your business from the advisory firm down the road and add value to your clients. On the other hand, it can potentially be a drain on resources, create potential conflicts of interest and be an added compliance burden. Once you embark on this path, it’s difficult and costly to unwind, and could do untold damage to your brand. It’s not a decision to be taken lightly.

 

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