YOUR PLATFORM OF FUNDS: INVENTORY OR TREASURE?

"Stocking the Shelves" - The First Step to Success

DUE DILIGENCE: A CRUCIAL PART OF PORTFOLIO CONSTRUCTION

Before we can select the funds that deliver our asset allocation, we must first establish a set of approved investments, from which we identify the ones most suitable for our portfolio. This “universe” of funds to pick from is our “fund platform” - and this is a critical component of the investment process. Why? Because we follow the prudent notion of “Risk first.” This means that our first task is to evaluate the risk of every investment decision and determine whether the type and level of risk that it brings are appropriate for the client. We demonstrated this “risk first” concept in our earlier articles, focusing on fiduciary responsibility, client goals, sensible withdrawal strategies and an asset allocation that brought all these structural and market risks and opportunities together. We now move to the stage of the investment process that turns our plan (the asset allocation) into a portfolio.

Our “risk first” approach requires that we identify a set of investments to choose from – and this is no small task!

Establishing a fund platform is a due diligence function that requires expertise in both the investment markets and the available funds in the marketplace. In addition to finding a set of desirable funds within each segment of the asset allocation, the due diligence team must also monitor these investments on an ongoing basis. This continual evaluation of performance and competitive position provides the risk monitoring required to ensure that investments remain suitable and effective. Once a set of approved investments is made available, portfolio managers can focus on selecting the ones that form a portfolio that meets (and hopefully exceeds) client goals. We see that the portfolio construction process is a partnership between the due diligence team and the portfolio management team.

The question before us is this: “Is the due diligence process and the fund platform an operational necessity, or is it a value-added component of client success?”

This paper demonstrates the potential for firms to showcase their fund platform as a key part of their value proposition. In the highly-competitive market of investment firms, we believe that this provides a source of differentiation and advantage.

A LOOK AT THE FUND PLATFORM IN ISOLATION

We grouped the 57 funds in our approved platform by their three major asset classes, The performance shown over this 12-year period (2005 – 2016) is the result of both market results and active returns. We see expected results across bonds and equities, with non-US equities underperforming on both an absolute and a risk-adjusted basis.

GROUPING FUNDS BY THEIR MARKET SEGMENTS

Grouping these funds provides a helpful context for evaluating the value of the funds contained within each market segment (i.e., growth vs value, large vs small, etc.) We equally weighted the funds within each segment to create its overall return and risk. These blended results for each segment incorporate the benefits from the complementary nature of its active funds, demonstrating the effects of both market diversification within each sector as well as “alpha diversification.”

The trend lines show that the platform’s funds outperformed their corresponding market benchmarks, and that the reward for bearing volatility risk was slightly higher for the active funds. The platform outperformed its market benchmarks in 9-out-of-11 segments. Adjusting for differences in volatility risk, it outperformed in 10-out-of-11 segments.

When we aggregate the segments up to their four major asset classes (US Equity, non-US Equity, High Quality Bonds, High Yield Bonds) we see that all the active groups outperformed their benchmarks on a risk-adjusted basis. We also observe that the platform’s active process delivers lower volatility risk; this is a desirable characteristic for the many clients who make regular withdrawals from their portfolios (since volatility risk is a threat to preserving portfolio capital in the presence of distributions.)

We believe that this suggests that there is value in simply “showing up” to the firm’s fund platform. We also believe that this benefit is even more persuasive when we evaluate the platform in the context of representative investment strategies.

LINKING FUND EVALUATION TO ASSET ALLOCATION

Our fund platform exists so that we can deliver the appropriate asset allocation to a client via actual investments. This is the essential difference between the portfolio and its benchmark: one is an abstract plan while the other is a set of specific funds that is expected to deliver a market return plus an excess return through the active process. This practical perspective provides a context for evaluating our fund platform:

• Does the platform include fund options in every segment of the asset allocation?
• Can we allocate across several funds within each market segment?
• Do the funds complement each other in their active strategies and results?
• Does the overall platform offer value in terms of the opportunity for active return enhancement?

This holistic approach allows us to manage the fund platform within the context of a true client-centered investment process. The fund platform is viewed in the context of the firm’s investment strategies, with an eye toward delivering superior risk-adjusted excess returns, driven by the client’s goals and risk tolerances for both market return and active return.

We begin with a “70-30” allocation to stocks and bonds, using the following strategy:

Using a traditional approach to relative performance, we see that the platform’s funds outperformed the strategy benchmark on both an absolute and a risk adjusted basis. We note that the platform portfolio earned an excess return of 61 bps, which is reduced to 46 bps after considering its higher volatility.

EVALUATING RESULTS OVER A RANGE OF STRATEGIES

We applied our platform’s fund results to a variety of investment strategies, ranging from very conservative (30% equity and 70% bonds) to very aggressive (80% equity and 20% bonds.) Across this range of asset allocations, the platform produced superior results, as measured by the return earned relative to volatility risk. The “benefit gap” between the active and the passive strategies appears to widen, driven by the additional risk and return that the active process adds.

FOCUSING ON TRUE ACTIVE RETURN AND TRACKING ERROR

Our focus on active return shifts the emphasis from naïve “excess return” to an “alpha” that accounts for differences in volatility between the platform sector funds and the benchmark. Alpha is essentially a “volatility-adjusted excess return.” When a fund’s volatility is higher than its benchmark, its excess return is lowered, and when the reverse is true, the excess return is increased. This more sophisticated approach to relative performance is in keeping with our “risk aware” perspective. It brings together active return enhancement in the context of both total return volatility and active risk via “tracking error.”

Using our initial 70-30 strategy, we illustrate the differences in results when using alpha instead of simple excess return. These differences can sometimes be striking, as in the case of the high yield sector. This sector appears to underperform dramatically (when risk is ignored) but is revealed to be a strong outperformer in the bond asset class, given its much lower volatility risk. The reverse was true for large cap growth, whose underperformance was much worse after adjusting for its higher volatility. Meanwhile, small cap growth appeared to be an underperformer, but was shown to provide a fair return for its lower volatility. The risk of mis-categorizing relative performance is removed once volatility risk is considered.

Our 70-30 strategy delivered its 61 bps of excess return with 128 bps of tracking error (i.e., the volatility of excess return.) The platform’s funds had an average individual tracking error of 451bps. After combining these funds into segments, their tracking error declined to 329 basis points. This demonstrates the complementary nature of the funds within each segment. This “alpha diversification” then was extended across all the segments, with this cumulative diversification eliminating over 70% of the funds’ individual tracking error.

PRAISING THE PLATFORM

It may be time to reveal a “hidden gem” in your firm’s active process: your fund platform!

We demonstrated an approach to determining the value that your fund platform brings to your clients:

• Access to a variety of investments to deliver the appropriate asset allocation
• Funds that are selected and monitored by risk management professionals
• Benefits from the complementary nature of the platform’s funds
• Opportunities to increase portfolio return while simultaneously lowering its risk

The fund selection process begins with the platform. Our example reflected about 50 bps of potential excess return simply from “showing up” to the platform to select investments. We expect that while “shopping” among the platform’s opportunities, your clients will find additional value in selecting the most appropriate funds that benefit from their active interactions; this carries a reasonable expectation of achieving even higher active returns while managing active risk.

These excess returns are key to helping clients achieve the target returns needed to meet their financial goals.

FROM PLATFORM TO PORTFOLIO

In our next installment, we move from “buying one of everything” to selecting specific funds to meet client return objectives. Our unique “team approach” evaluates funds in the context of the portfolio, rather than following the traditional method of focusing on performance “in isolation” relative to each fund’s benchmark.

We will focus on the contribution that each fund makes to both portfolio excess return and portfolio tracking error.

By adding risk attribution, we fill a gap in performance evaluation that has persisted for the past three decades. The complete picture of return contribution vs risk contribution is the key to building superior active portfolios.

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Written in partnership with Stephen Campisi