• Active risk tolerance. The final factor our framework considers is patience, that is, does the client have the temperament, or the patience, to wait out shorter-to-medium term losses in order, eventually, to access the alpha opportunity? We know that even talented active managers will inevitably have periods of underperformance and some of these periods of underperformance can be quite long. Is the client prepared to stay invested during these periods?
We believe these are the four key ingredients to succeeding in building blended investment portfolios. Advisers need to pin their colours to the mast and make their implicit expectations explicit. Working through these factors in a systematic way will help advisers to show that their decisions are deliberate, rational and based on evidence. It is the basis of a process that is structured, repeatable and defendable.
The result is a process that can better educate clients about what a portfolio is trying to achieve, and what risks are involved. And a clear, agreed understanding of a portfolio’s objectives and risks is often a key to stronger adviser-client relationships.
Active management checklist: steps towards a working strategy
In our view, passive investing is the starting point for clients, if for no other reason that that it’s simple and low cost, merely seeking to capture a market’s return. But active can play an important role. The key is to recognise what it takes to succeed in active management over long time horizons.
A successful active strategy depends on three critical elements:
• Talent. To deliver long-term outperformance, a fund manager needs talent. This is a lot more than clever ideas and polished patter. It’s a strong team, a time-tested philosophy, and a clear, consistent investment process.
• Cost. The total return of a fund consists of three parts: beta, factor, and alpha. The beta and factor components typically explain most of an investment’s return, and they can be obtained at low cost. Our task as investment professionals is to make sure that any additional costs are commensurate with expected alpha. A rule of thumb? The lower the cost, the better the chance for net alpha.
• Patience. This can be a challenge, and this is where the quarterly performance derby can do so much damage. Every active manager underperforms the benchmark at one time or another. There may be occasions when this underperformance stretches over years. Does your client have the patience to sit tight through periods of relative weakness?
