Know your process

Very early in my career, I emphasized more goals-driven portfolio design rather than buying a collection of products to build a portfolio. Both methods sometimes lead to the same end point.

But better investment outcomes are much more likely when using a process that begins with discovery and profiling, and integrates rigorous planning to provide key portfolio-construction inputs.

For example, the target return is a key input for the design of every portfolio. Without prudent planning, this input is set with an arbitrary number, which almost always is influenced by recent market moves and often is unrealistic. Completing all of the planning work first provides a target return that is more realistic and specific to a client’s goals and objectives.

After completing a financial plan, you can design an investment policy. A risk profile is a key part of this and uses a combination of a standard questionnaire and meaningful discussions about risk.

At this stage, you have everything you need to figure out what kind of asset-class exposure your client needs. And only then – at the end of the process – should you begin searching for products, which can be done with much more direction and focus.

If you decide that some form of factor investing is appropriate for part of the portfolio, your next challenge is to have a firm understanding of exactly what that entails.

– Know what you’re recommending

Factor investing goes by many names: rules-based investing; enhanced indexing; smart beta; fundamental indexing; strategic indexing; quantitative investing. The one name that rarely is used is the one I like best: quantitative active investing. I like this label for its clarity.

Consider, for example, dividend growth, low volatility, equal-weight “index” or fundamental “indexing.” Each uses a distinct strategy and yet they share one important trait: each of these strategies was designed to improve upon (read: “outperform”) market capitalization-weighted indices. That is the same basic goal of virtually every active portfolio manager.

Although the ETF product segment continues to be associated with plain-vanilla indexing, most ETFs have some form of active portfolio management. And successfully employing actively managed products requires rigorous analysis to assess, recommend and monitor selections – easier said than done. One example of this is scrutinizing back-tested performance.

Every quant strategy that’s packaged and sold in product form boasts historical back-tested outperformance of market-cap indices. But far from 100% of these strategies actually will deliver on their hype. Key to sound due diligence are understanding: the finer details of the strategy; the reasons for its past hypothetical outperformance; an assessment of the validity of the back-testing; and a sound rationale for why you expect outperformance.

This kind of sound due diligence will go a long way toward improving client portfolios and keep you ahead of evolving “know your product” rules.

Dan Hallett, CFA, CFP, is vice president of Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.