INVESTMENT POLICY
This document is a formal record of the policy operated by Ethos Financial Management in practice for several years and had been refined and clarified in October 2009 for benefit of all staff involved in preparing or offering investment advice. It is made available to clients and potential clients on our web site.
The value of investments can fall as well as rise. You may not get back the original amount invested.
The policy covers 4 areas:
1. Client Risk Assessment
2. Defining Objectives
3. Choosing an Asset Mix and Selecting Funds
4. Review processes
Client Risk Assessment
Risk assessment is a very important part of the financial planning as an investment can be suitable only when the client fully understands, accepts and feels comfortable about the risk they are taking with their money. The client has to fully understand the existence of the positive correlation between risk and possible gain. Therefore the first step is to discuss with the client the various aspects of risk and to complete a risk profiling questionnaire.
Advisers will use one of several questionnaires that are available to support computerised risk modelling software tools. Although advisers are free to use any questionnaire that is sufficiently detailed to cross check client attitudes, the firm will normally expect that where a particular software modelling tool is being used, the questionnaire supplied by the software designer has been completed.
The firm recognizes that it is overly simplistic to define risk in terms of very short phrases such as "low" or "balanced". In communicating risk to clients, the firm will seek to be more specific, relating the risk to the client’s circumstances and giving examples. So in explaining the risks to a client commencing income drawdown, a suitability letter might include the following phrasing: "You have indicated that you are concerned about the risk of your income reducing because your investment portfolio has fallen in value. We have therefore selected investments across a diverse range, some of which will be less volatile and can be easily accessed to provide you with income on a regular basis. The long-term investment portfolio strategy would be described as low to medium risk."
Where shorthand phrasing is used in summarising the risk level of an investment strategy, examples of what that actually means will be given. So in explaining medium to high risk, an adviser might say: "This portfolio can be considered as medium to high risk over a term of five years or more but includes components that will be less volatile in the short term as well as other investments that may change in value, both up and down, by significant amounts over shorter periods. It would be possible for the portfolio value to vary by as much as 30% to 40% over a one-year period."
When communicating with clients, the firm will where possible seek to avoid the use of jargon or phraseology that is outside of the client’s known a level of education or experience. For example, it would not be appropriate to refer to standard deviations when explaining a chart of potential portfolio outcomes unless it was known that the client had a suitable education in mathematics or statistics or their occupation would suggest they would be familiar with probability analysis. Normal language will be used to explain formal methodology in most cases. For example, standard deviation could be explained as the extent to which an investment moves up and down in value by more than the average of a range of similar investments.
The firm will use visual aids such as charts, diagrams and on line interactive tools to demonstrate the implications of accepting various levels of risk, but such tools must be used only after the adviser is fully familiar with the underlying data handling processes and able to use the tools in a way that is not misleading or inappropriate. Where non-generic, client specific documentation is supplied, copies will be retained in the client’s Research file.
The firm recognises that risk attitudes change over time and according to absolute levels of wealth. Risk attitudes will be reconfirmed on a regular basis.
Objectives
We seek to know our clients financial requirements well. During the initial fact finding and at review meetings advisers try to identify all the possible needs the client has as well as to help clients to prioritise the needs.
It is recognised as a fact of life that clients will have multiple objectives and even conflicting objectives and that financial planning is a process of route planning with multiple paths available to the destination in most cases. Our task is to help the client understand what needs to be done with the available financial resources to achieve some or all of the agreed objectives, and to ensure that the client understands that in the majority of situations, there is no certainty of success.
It is important to explain to clients that as financial circumstances, both personal and external, will change frequently, a review process is necessary. At reviews, progress towards objectives can be checked and alterations made to reflect to new information. If a client will not agree to a review cycle, then the increased risk of the objective not being achieved will be emphasised in communications. In some cases, it will be inappropriate to act for a client at all if no review process is installed (e.g. income drawdown).
Choosing Asset Allocation and Portfolio Mix
Having established an objective or series of objectives and agreed with a client how to handle risks in a way that matches their attitudes, we carry out our research and portfolio design in 2 distinct stages:
Asset Types
First of all, a decision is made to decide what type of asset classes should be included in the portfolio so that it would meet the client’s risk level (e.g. the mix of UK equities, bonds, commercial property funds and overseas funds). The initial asset mix will usually be a direct consequence of the answers given in the risk assessment questionnaire. A further consideration will be any cash flow requirements (e.g. for pension drawdown).
The underlying concept that mixing assets lowers risk, in terms of overall portfolio volatility is based on “modern portfolio theory” and the simple rule that risk and reward are correlated. It is assumed that it is the objective of the investor to minimise this correlation in one direction, that is to get more reward without an identical or greater level of risk increase. It is clearly impossible to achieve higher rewards without some increase in risk, so our efforts in portfolio construction are directed to minimising the incremental increase in risk for each unit of increased return. Having the right asset mix, including especially the right weighting to cash to fund liquidity needs, is a key part of this process.
We generally use some computer modelling software that uses a mathematical methodology called stochastics to measure the probability of various outcomes for different asset mixes. The actual software will be whatever is the latest version in the market that is assessed by us as being reliable and which produces outputs that are easy to understand if presented to clients. The output of such models is a useful guide but we also apply our own experience and judgement so as to allow for the fact that the model is based on 10 years historic data and at any given point in time, the risk assessment will be influenced by those 10 years and will not necessarily reflect what we think will happen in the next 2 or 3 years
Fund Selections
It is well known that most investment funds do not beat a benchmark index and as index tracking investments such as ETFs (Exchange Traded Funds) are cheaper to buy, there is a limited argument for paying for fund management. Media comments typically suggest that 80% of retail funds underperform a simple benchmark index (eg the FTSE 100). That means of course that 20% outperform and that is still large pool into which we can go fishing, assuming of course that we know what distinguishes the top 20% from the rest.
Our objective is to have at least 75% of the money we have invested for clients in funds that are above their peer group average over the last 3 and 5 complete years and to have the majority of their money in funds in the top 25% (i.e. in the first quartile of the sector as defined by the Investment Managers Association - the IMA).
If the asset mix is right and the fund managers beat the average, it is highly likely that the whole portfolio will perform well and true value will be returned to more than pay for the investment manager and adviser fees.
After the asset allocation is set, we examine a shortlist prepared by the M & E Network’s research team which uses quantative measures provided by external firms such as Standard & Poors/OBSR/Lipper to try and assess the long term success of individual fund managers. Relative risk being taken within the individual funds is also checked to see how that relates to returns achieved. We also keep up to date with new fund launches and will seek to add brand new funds to our shortlist if there is a strong case for investing in a new strategy or market.
The financial strength of the fund management group and its ability to deliver reasonably efficient administration at a fair price are factors that are also taken into account.
Regular teleconferences with the fund managers and meetings with managers face to face or at open meetings help us to have a better idea of how the funds work, what strategy managers have and how rigorously they apply the published investment methodology. The personality of the manager and commitment to the job can only be assessed in this way, so we rarely recommend funds where we do not have some way of hearing from the manager directly, in person. The exceptions are usually smaller overseas funds, or funds where the management is by a formal technical process with less personal intervention (e.g. funds run on a matrix or filter basis, or a single over riding rule such as an income yield target)
During the research process a fact sheet for every individual fund is accessed and will be supplied to the client in paper or electronic form. Such documents have limited use unless interpreted with care, although some (e.g. from the research company Morningstar) do have extensive content reporting a variety of performance assessments in graphical form.
Past performance is one measure we look at, but it is not a useful guide to future performance on its own, only an indicator of how successful or otherwise the manager’s method has been historically. It can also give an indication of consistency.
The overarching factors is deciding to include a fund are an understanding of the style and methodology of the fund manager, an assessment of its suitability in the prevailing economic climate and how it will be useful as a complimentary part of a diversified portfolio.
So in summary, our tests might be stated as:
• Is the fund manager working for a well resourced financially stable group?
• Is there evidence that the manager has run a fund of this sort successfully in a variety of business and economic climates? Do the fund manager's comments as reported in the fund literature fit with our own assessment of the markets and the opinions of his or her peers? If not, can he or she justify his or her contrarian position?
• Are the costs of buying and holding the fund reasonable?
• Does the style of the manager correlate or differentiate from other funds we want to include in the portfolio?
• Are there any specific risks with this fund that need to be fully understood and accepted? If complex or unusual investment methods are being used, especially those involving derivatives or counter parties, do we fully understand how they work and what evidence is there that such extra complexity is beneficial?
• Can we meet the fund manager, in person or online, to hear up to date reports on the fund and question his or her results and strategy?
Various industry benchmark scores that rank funds (e.g. Lipper, OBSR, Citywire) are also useful, although they are again mainly based on past performance, with perhaps some qualitative components added.
After funds have been selected it is possible to check back to see how the particular funds in the asset mix would have performed together on a “back tested” basis using simulation software. Using such tools, we can also see to what extent various funds are correlated and how they have performed in various different market conditions. Various industry benchmark scores that rank funds (e.g. Lipper, OBSR, Citywire) are also useful, although they are again mainly based on past performance, with perhaps some qualitative components added.
Finally, we check from time to time to ensure that our portfolios perform at least as well as “off the shelf” fund of fund offerings, managed portfolios from external managers and simple managed collective funds. This is usually done by comparing a particular client portfolio with an externally managed fund with similar objectives. As all of our client portfolios are bespoke, we cannot carry out a general comparison of the results of our advice with a single external benchmark.
We are prepared in all cases to include an externally managed holding in a portfolio over a given period of time, so as to have an exact comparison with the fund mix that we have advised be bought and held.
Reviews
The need for regular reviews is emphasised. As a rule, the firm will not offer investment advice services to clients that do not wish to contract for a review service. An extra cost is inevitably involved, but this is agreed on a client by client basis and is fixed, not set at a percentage of assets invested.
Reviews will be at least annually and for larger portfolios, half yearly or quarterly. We do not believe in or operate a policy of rebalancing holdings back to an initial target asset allocation at fixed intervals. Experience shows that the recommended asset mix alters as a consequence of the fundamentals changing over time, so rebalancing to a target seen as suitable some years ago is illogical.
At reviews, the asset mix will be re-examined and the relative performance of all the funds assessed by comparison with the IMA per group.
For the more complex portfolios we also provide a range of charts measuring performance and volatility.
Clients will be offered a face to face meeting at review dates and a written report is supplied in all cases. Portfolio changes will only be recommended where clearly justified and we expect relatively low turnover. Any need to provide liquidity is dealt with at reviews and advice to take profits or close off mistakes will always be offered.
Clients can request interim reviews on request. On rare occasions, a special market situation will result in the firm sending a request to all clients to review a particular investment. In general, changes in fund managers, holding group ownership or the fund’s stated policy take time to have any impact (as the underlying holdings will not be immediately swapped for different stocks), so such unpredicted events can be handled at routine review meetings in most cases.