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Robert Arnott. – Founder and CEO of Research Affiliates
For investors who adopt a systematic buy-hold-rebalance approach to investing, it can be tempting to question why the portfolio seems to be largely unchanged from one period to the next and what the firm is doing for its fee. That would be unfair.
Wear a risk manager’s hat, not a performance manager’s hat
A good place to start is to look at the investment process, not from a performance perspective – as most stock brokers and investment managers tend to do – but from a risk perspective. Performance-focused managers inevitably look busy as they regularly change portfolio allocations and fund holdings; yet more activity does not equate to better outcomes. Plenty of evidence exists to back this up. Those who focus on chasing returns are at susceptible to taking unknown or poorly understood risks and getting it wrong. They also incur higher costs. On the other hand, focusing on taking risks that are fully understood and adequately rewarded offers an investor every chance of a successful outcome.
Your portfolio, as it stands today, should provide you with the comfort that it is robust under the wide range of testing scenarios that could be thrown at it by the markets. Let’s consider some of the key risk decisions that have been made when establishing it.
- Key decision 1: own a highly diversified pool of global companies to avoid concentration risks and capture the broad returns of capitalism.
- Key decision 2: tilt the portfolio toward higher risks, such as value (less financially healthy) and smaller companies to pick up incrementally higher returns
- Key decision 3: own shorter-dated, higher quality bonds to balance equity downside risk. Chasing higher yields in bonds simply dilutes their defensive qualities. The lower the credit quality the more these bonds act like equities.
- Key decision 4: use systematic rather than judgemental fund managers. Although picking a manager who promises to beat the market sounds appealing, the stark reality is that true skill is hard to discern from luck, it is extremely rare, and it is almost impossible to identify in advance. Employing managers who capture the returns delivered by taking on specific market risks makes good sense.
- Key decision 5: avoid owning an increasingly risky portfolio by rebalancing. Over time, the more risky assets (equities) in a portfolio tend to rise in value and begin to overpower the more defensive assets (bonds) in the portfolio. Periodically realigning – or rebalancing – a portfolios back to its original structure avoids this risk.
The role of the Investment Committee
The firm’s Investment Committee is responsible for the oversight of these risks in client portfolios and the wider investment process. Meetings are held regularly and minutes are taken, which include all action points to be followed up on. Third-party inputs and guest members provide valuable independent insight, where necessary. Its responsibilities include:
- Responsibility 1: ongoing challenge to the process. If new evidence suggests that doing things differently would be in clients’ best interests, then the firm will revise its approach. The investment process is evolutionary, but change is most likely to be rare and incremental.
- Responsibility 2: review of the best-in-class funds recommended. Each fund has a role to play in a portfolio and its ability to deliver against this objective is regularly reviewed. Any fund-related issues are raised and resolved, although this is pretty rare.
- Responsibility 3: review the portfolio structure. Risks (asset class exposures) and their allocations within a portfolio are evaluated and from time to time these may change as the firm’s thinking evolves, given the latest evidence.
- Responsibility 4: screen for new funds. New, potential best-in-class funds face detailed due diligence and approval, before they are recommended to clients. It would take a material improvement to knock an incumbent fund off its perch, but it can and does happen from time to time.
- Responsibility 5: reaffirm or revise the investment process. Risk (asset) allocations and fund changes are approved by the Investment Committee. Any actions arising from portfolio revisions will be undertaken, after discussion with, and agreement by, clients.
It is entirely possible, and likely, that your portfolio will look much the same between one time period and the next with little activity, except for rebalancing. That most definitely does not mean that nothing is happening. In fact, it takes quite a lot of work to keep our portfolios the same!