Canada’s wealth management industry is insufficiently contextualized and nuanced when it comes to product risk in general and portfolio risk in particular. Risk is assessed strictly on an individual product basis.
The problem is that the same product can have different risk and return characteristics depending on where we are in the business cycle. For example, an investment product — a mutual fund or ETF for example — that is benchmarked against the S&P 500 is quite likely to be rated as a medium-risk product. Always.
However, that rating does not consider the valuation of the index. The cyclically adjusted price earnings (CAPE) ratio for that index has been between 35 and 38 for about three years now. Historically, the CAPE on the S&P 500 is about half that.
In other words, the numerator (i.e., the price in any P/E ratio) could drop by half and the benchmark would still be trading at a historically average multiple. That represents a degree of risk that current product assessments, risk ratings and new client application forms (NCAF) do not account for.
The result is that a large number of investors are unwittingly taking on more risk than they realize.
It is well known that CAPE is all but worthless for market timing in the short to medium term. However, it is also widely accepted that it is an excellent predictor of what one might reasonably expect over the course of the decade ahead.
A CAPE reading in the high 30s is likely to produce a compound annual growth rate of close to zero for the following decade. That strikes me as risky.
Return maximization
The research done by Daniel Kahneman and Amos Tversky shows that investors feel the pain of a loss twice as acutely as the joy of a gain. Despite this, many advisors promote their services in terms of return maximization rather than risk management and minimalization. This is especially concerning for retirees, who not only have a shorter time horizon, but who also lack the capacity to buy the dip when markets pull back.
Over the past few years, the suitability metrics of an NCAF have changed. It used to be that compliance people wanted to see an asset allocation that conformed to the client’s risk tolerance. I don’t think that is wrong, necessarily, but it is presumptive and possibly incomplete.
How, exactly, does a traditional pigeon-holing of stocks, bonds and cash translate if the client holds a significant portion of their wealth in alternative assets? Many bank-owned firms are notorious for limiting access to alternative assets in the first place, thereby forcing their registrants to build portfolios using more traditional assets that might be at a risky point in the market cycle.
These days, what matters is that portfolios align with the account holder’s risk tolerance and risk capacity. There is a regulatory imperative to manage accounts to the more conservative of those two benchmarks.
There are dozens of alternative products that are properly rated as having a medium risk profile that are, in this environment, often likely to be less risky than more conventional options. Despite this, many of these entirely suitable products are being needlessly precluded from some firms’ product shelf due to either corporate imperatives or a dogged resistance to the spirit of what regulators are trying to achieve.
Clients deserve the widest possible menu of options in a volatile world. Many firms are making that a challenge.
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