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planning versus investing

Planning's Future, Practice Management

Price discovery Vs. Values discovery: Should Advisors Search for Alpha or Gamma?Featured

 

head-hunters-hire-your-competitors-top-sales-people claw machinePrice discovery: the alpha-seekers dilemma

In his recent Financial Analysts Journal article ‘The Rise (and Fall) of Performance Investing[i]”, Charles Ellis among other things, frets that improving market efficiency increases the difficulty of locating managers who will produce consistent alpha. He reminds us “Price discovery is the skillful process of identifying pricing errors not yet recognized by other investors.” Ellis observes”… the skill and effectiveness of active managers as a group has risen for more than half a century, producing an increasingly expert and successful (or “efficient”) Price discovery mechanism.”

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The article postulates;”As the skill of competitors converges, luck becomes increasingly important in determining the increasingly meaningless performance rankings of investment managers.” It warns “Investment professionals know that any long term performance record must be interpreted with great care.” As evidence, Ellis offers a study of investment performance produced using manager selection consultants. “Despite considerable time and effort and access to managers’ data, the self-chosen task of investment consultant firms has proved far more difficult than expected. As a group, selection consultants have caused their clients to underperform by 1.1% of assets.”[ii]

keep-calm-and-set-meaningful-goals dnldValues discovery: bold proposition or capitulation?

Given the uncertainty of finding managers who will consistently add alpha, Ellis suggests we re-emphasize “Values discovery” in our client relationships; which he defines as “…the determination of each client’s realistic objectives with respect to various factors, including wealth, income, time horizon, age, obligations and responsibilities, investment knowledge and personal financial history, and designing the appropriate strategy.”

 

 

Does Values discovery produce measurable results?

Happily, according to recent Morningstar research, Ellis’ “Values discovery” earns our clients, large, tangible returns. In their Morningstar paper “Alpha, Beta, and Now … Gamma”, authors David Blanchett and Paul D. Kaplan[iii] “… introduce a concept called “Gamma,” which is designed to measure the additional expected retirement income achieved by an individual investor making intelligent financial-planning decisions.

“Measuring Gamma: Although financial planning spans a tremendously broad range of potential decisions, in this paper, Blanchett and Kaplan start out by measuring Gamma for five specific retirement-based planning issues: determining asset allocation based on total wealth; applying a dynamic safe withdrawal rate strategy; incorporating guaranteed retirement income products (e.g., annuities); making tax-efficient allocation (i.e., asset location) decisions; and optimizing the portfolio by treating client cash flow needs as liabilities and matching investments and their risks appropriate to manage (and hedge) those liability needs”[iv].

Values Discovery is more powerful than price discovery

Surprise: Values discovery is more accessible and powerful than Price discovery

To gauge planning’s contribution; the research compares a base case – what investors do on their own, against against a set of retirement planning strategies. While the improvement varies with client circumstances, the authors found the planning strategies make a significant difference;”… a Gamma of 28.8%, meaning $1.29 for every $1 generated by the base set of assumptions.[v]” So taking a smarter approach to generating retirement income (by working with a planner) earns investors substantial tangible rewards. Unlike Alpha, everyone can earn Gamma because better planning is not a zero-sum game.

Values plus Price discovery create a viable client planHolistic approach: blend Values and Price discovery

Based on evidence that used alone, each yields much less benefit than the combination, orthopedists prescribe a combination of surgery and exercises to treat an injured limb. Similarly, Ellis describes the practice of investment management as “two hands clapping”; “…one hand based on the skills of Price discovery and the other based on Values discovery.” Advisors employing the two-handed approach blend Alpha and Gamma consistent with their firm philosophy and appropriate to each client.

Ellis concludes “[Values discovery] is an admirable way forward that would inspire client loyalty—with all the attendant long-term economic benefits—and would provide practitioners with deep professional satisfaction. Although not as exciting as competing on Price discovery, investment counseling based on Values discovery is greatly needed by most investors—institutional investment committees as well as individual investors—and surely offers more opportunities for real long-term success to both our profession and our clients.”

 

[i] Charles D. Ellis, CFA; “The Rise and Fall of Performance Investing”, Financial Analysts Journal, July/August 2014 pages 14-23 Article Link see also Article Link

[ii] According to Tim Jenkinson, Howard Jones, and Jose Martinez, “Picking Winners? Investment Consultants’ Recommendations of Fund Managers,” Article Link

[iii] David Blanchett and Paul D. Kaplan; “Alpha, Beta, and Now … Gamma Measuring the importance of intelligent financial planning decisions.”, Morningstar Advisor December/January 2013 pages 60 -63 Article Link

[iv] Morningstar Tries To Quantify The Value Of Financial Planning – 1.8% Gamma For Retirees?, Posted by Michael Kitces on Monday, November 12th, 12:01 pm, 2012 in Planning Profession. Article Link

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Sensible approaches to Planning and Advice

Makes Sense to me: some ‘Rules of Thumb’ for managing retail clientsFeatured

If not self-evident, nearly so.

If not self-evident, nearly so.                                                                        Image Info

 

Working with clients

Select Processes based on benefit and certainty

Select processes by benefit and certainty

 

  • Control the controllable; create measurable client results with reliable and predictable techniques.
  • Start the triage of client care with the most certain & beneficial actions leaving for last measures offering smaller, less certain benefits.
  • A client’s investments are best viewed in light of their “risk capacity” (assets/liabilities.)[i] The client’s investment design becomes a result of identifying that capacity through basic financial planning and budgeting.[ii]

 

 

 

 

 

 

 

 

 

The roles of active and passive investing in retail portfolios 

Tortise and Hare

Active strategies

  • Can improve risk/return profile by consciously managing exposures to discrete risks (e.g., sectors, issuers, liquidity, currency, etc.)
  • Offer the hope of limiting exposure to over-priced securities in over-valued markets, while most benchmarks, blind to valuation, may overexpose investors to overpriced securities, sectors or asset classes.[iii]

Passive strategies

  • Can reduce portfolio expense and improve diversification by delivering specific beta-exposures at low cost.

 

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Searching for exceptional investment managers

haystack_aab

  • Alpha[iv] exists; it is statistically true in any period some managers consistently outperform their benchmark. Those top-performers change over time as asset classes and investment styles move in and out of favor.
  • It is very difficult to hire exceptional investment skill because (i) true ability is rare and hard to predict and (ii) managers have limited capacity and (iii) thousands of other advisors, pensions and endowments compete to hire the same skill.
  • Institutions have many advantages versus retail investors in competing for the best managers; institutions offer large $ mandates, can commit quickly and analyze performance more patiently and methodically. [v]
  • The more relevant question; “What consistent, reliable benefit do retail clients and their advisor gain from emphasizing alpha (selecting out-performing managers)?”
  • Picking exceptional managers, an unpredictable task with uncertain benefit, is by itself unlikely to meet client needs or insure an advisory practice’s success.

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Investing retail clients with an ‘Endowment Model’

Four Boston campuses

  • The “endowment” model of investing is not suitable for any retail client facing the possibility of exhausting assets.
  • The risk tolerance of endowments far exceeds the average person because endowments are perpetuities managing spending over very long time horizons and able to augment assets through campaigns.

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Table Endowment and Retail Investor characteristics

 

 

 

 

 

 

Marketplace paradox that does not make sense to me

Inconvenient truth versus reassuring lie

While clients earn the largest most reliable benefits through “planning”[vi], the retail market is dominated by clients seeking and advisors offering investment advice.

 

 

 

 

 

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[i] For a more thorough discussion of risk tolerance and capacity see Michael Kitces/Nerd’s Eye View “Separating Risk Tolerance From Risk Capacity” Article link

[ii] Aspirational investing is appropriate for clients with surplus risk capacity.

[iii]  Not all passive strategies are good investments. Some permit excessive exposures due to issuance/buy-backs or blindness to overpricing. Others simply lose performance; for example stock benchmarks with highly predictable buys and sells are easy targets and lose performance to arbitrageurs.

[iv] “Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index used as a benchmark, since they are often considered to represent the market’s movement as a whole. The excess returns of a fund relative to the return of a benchmark index is the fund’s alpha.” See Investopedia definition

[v] In spite of their advantages, institutions don’t boast a great track record of selecting exceptional managers. Notes Charles D. Ellis, CFA in “The Rise and Fall of Performance Investing” Article link ; ‘Despite considerable time and effort and access to managers’ data, the self-chosen task of the investment consultant firms has proved far more difficult than expected. As a group, selection consultants have caused their clients to underperform by 1.1% of assets, according to Tim Jenkinson, Howard Jones, and Jose Martinez research…’

See also “Picking winners? Investment consultants’ recommendations of fund managers” Article link

[vi] See Michael Kitces’summary Article link. See also the original Morningstar Research by Blanchett and Kaplan Article link.

Continue reading
Related posts
Forecaster builds the most accurate forecast, refuses to believe it
January 8, 2017
(complete) Beating the market has become nearly impossible by Julie Segal Institutional Investor September 18, 2013
August 31, 2016
Price discovery Vs. Values discovery: Should Advisors Search for Alpha or Gamma?
August 30, 2016