Imagine the following scenario: a new client who is 55 years old, married and looking to invest $150,000 he obtained from a severance package goes to see a prospective advisor. The advisor works his way through the financial planning process and the client decides to engage the advisor’s services.

The advisor then completes the “know your client” information. During the KYC process, the clients informs the advisor that he is 80% for medium risk and is willing to hold 20% in higher-risk assets. The advisor recommends a portfolio of five medium-risk value-oriented equity funds: two that are invested in Canadian equity, two invested internationally and one invested in the U.S. The client agrees with the recommendation and the “buy” orders are entered.

However, the compliance department calls the advisor the next day and informs him that he is offside with this recommendation.

Why? Because the client has no high-risk funds in the recommended portfolio.

And as hard as that may be to believe, this real-life scenario highlights a major flaw in the way some in the industry evaluate suitability. In many cases, compliance departments and regulators are judging suitability in terms of the individual securities — which, in this example, would be the individual funds — rather than in terms of portfolio suitability.

But even though I would agree that the recommended portfolio in this example is flawed, I would say that it’s for a very different reason. This portfolio is of high risk — not because the fund managers have an aggressive investment philosophy but rather because, from an asset-allocation perspective, this portfolio is 100% invested in equities. And while we might accept that these funds are of low risk, they are low-risk equity funds, which is very different from low-risk bond funds.

Furthermore, geographical diversification aside, this portfolio is made up of five value funds that are essentially following similar investment styles, using a basket of equities that are probably positively correlated. You might argue that, geographically, these regions may be at different stages of their business cycle, implying that some diversification exists. However, we cannot ignore the fact that we are living in a global, interconnected village, implying that equities move in similar patterns. Bull and bear markets are contagious, and rising tides lift all boats.

Suitability should be viewed within the context of a portfolio. After all, are we not taught time and time again that asset mix determines 85%-90% of portfolio returns? If we believe that concept, then why are we fixated on measuring risk and return profiles of individual securities and/or funds?

In this example, the client’s profile would suggest a balanced mandate, implying a mix of bonds, stocks and cash. Beyond that, if we are to build suitable portfolios, they should conform to the rigours of efficient markets and the capital asset pricing model. Simply stated, securities that you are recommending for a portfolio should be analysed within the context of the synergies they bring to assets already in the portfolio.

And that means analysing funds — or stocks — on the basis of risk, return and a correlation matrix. It also means finding a middle ground between bad diversification that simply removes return with little impact on risk and good diversification that maintains returns and reduces risk. The efficient portfolio seeks to earn better risk-adjusted returns.

It is not clear why compliance has chosen to tie suitability to the risk profile of individual securities and individual funds. On the surface, it seems counterintuitive. If the pension industry were to apply the same suitability standards that many compliance officers typically use, then the Ontario Teachers’ Pension Plan Board would not be able to own a part of the Toronto Maple Leafs sporting empire.

Think about it: a pension plan is a low-risk investor. Maple Leafs Sports and Entertainment Ltd., no matter your particular view of the company, is by definition a small-cap private illiquid company in which the pension plan has a significant stake. By definition, MLSE would be viewed as a high-risk investment and would not be suitable for a conservative investor, which is what the OTPPB is.

So, where does this leave us? The OTPPB has professional managers who are not in the business of making bad, high-risk decisions. Within that context then, MLSE is a reasonable investment because it represents a minimal position within the portfolio. Whether MLSE ends up being a successful investment or falls to zero — neither scenario being the most likely outcome — it would not detract nor would it add significantly to the well-being of teachers who are relying on the OTPPB to deliver their promised retirement benefits.

@page_break@The point is, on all counts, suitability is being measured within the context of the portfolio.

Going forward, this column will highlight advisor and industry issues from a couple of perspectives: first, we intend to help advisors quantify the synergies between securities within a portfolio, with the objective of building a better portfolio mousetrap; second, we intend to challenge conventional views by encouraging debate among self-regulatory organizations, regulators and compliance departments, with the objective of redefining the context on which we measure suitability.

This could not come at a more important juncture, as there are new products with increasing complexity coming onto the market daily. As well, we are not serving client interests by evaluating a complex instrument in terms of whether it is suitable as a stand-alone product. All we do is end up eliminating good products because they are complex and including silly products because we perceive them to be of low risk. Products offered by Portus Alternative Asset Management Inc. were a case in point.

If you believe, as I do, that only the portfolio matters, then feel free to send questions and comments, which we will attempt to examine in the future. IE



If you have comments or questions, please contact Richard Croft at Croftfin@aol.com.