While rationally we know that the next downturn or market crisis will probably not be the worst ever, a large percentage of investors will always remain convinced that financial doom lies just around the corner. Behavioral science provides some explanation for this, since investors tend to overemphasize and fear unknown future risks while downplaying the emotional impact of financial upheaval once it is in the rear view mirror. (This cognitive bias is sometimes referred to as “hindsight bias,” the sense that we ‘knew it all along.’)

In another sense, though, this common perception of impending catastrophe is also due to our industry’s own persistent lack of preparation in the face of unfamiliar risks and predictable unpredictability, thanks to a critical failing in traditional approaches to asset allocation. In short, many managers mistakenly conflate diversification—which can help reduce volatility under some market conditions—with true risk management, which may require a significant shift in a fund’s tactical and strategic outlook in order to protect investors when bear markets or unforeseen “black swan” events occur.

As more and more financial advisors elect to outsource some of the routine day-to-day functions of investment management to third-party asset management platforms, or TAMPs, the divide between platforms that feature robust, quantitatively-driven risk management measures and those that continue to adhere strictly to traditional asset allocation approaches will only become more pronounced—and will drive profound consequences for both advisors and their clients.

Check Your Assumptions

While we drone on to investors that “past performance is no indication of future results,” most traditional asset allocation models are still built on the assumption that correlation between various asset classes will look the same next month as it did last year.

The problem is that, in reality, correlations can change drastically when market conditions shift. As the most recent financial crisis demonstrated, this blind spot in traditional allocation models can leave investors and fund managers in panic mode when correlation between disparate assets suddenly goes to one.

Advisor Due Diligence—What To Look For In A TAMP

In order to select the best TAMP for their practice and their clients, it is incumbent on financial advisors to subject potential platform partners to a rigorous due diligence process founded on a new approach to asset allocation and risk management. What should advisors be looking for as part of this process?

1. Top-down approach to asset selection—not 60/40 or any other “conventional wisdom.” Traditional allocation models too often assume that, depending on an investor’s age, he or she should own a set percentage of stocks, bonds and other securities, with no consideration given to the overall attractiveness or unattractiveness of those asset classes at the time. (In some cases, managers are even prohibited from breaking with prescribed allocation percentages.)
 

Too often, this hidebound approach leads to portfolios that are not built to capture attractive current opportunities or protect investors adequately against risks, since it rests on the shaky idea that diversification alone can provide sufficient downside protection.
 Financial advisors looking for a TAMP with both sophisticated risk management capabilities and the ability to pursue compelling investment opportunities should start by asking if potential platform partners have the macro-economic expertise and analytical insight to gauge the risk / reward balance of a range of asset types, as well as the flexibility to build portfolios accordingly—regardless of what traditional guidelines may say.

 

2. Focus on investment plan parameters rather than “style labels.” Sophisticated portfolio construction alone will not protect an advisor’s clients unless it is coupled with the ability to shift both tactics and strategy in response to changing market conditions. What happens, for example, when the benchmark index underlying a portfolio suddenly starts exhibiting more risk than expected? In many cases, the right move may be to detach from the index or move disproportionately into cash—and the TAMP’s managers will need to have the wherewithal and flexibility to do so.
 

With this in mind, advisors should look for potential TAMP partners that have developed quantitatively-driven, almost Boolean (‘if X, then Y’) processes for adjusting their investment parameters – across entire portfolios if necessary—in response to an unexpected increase in volatility or other bear market conditions.
 

Conversely, advisors should be cautious of TAMPs that follow narrowly self-constraining investment approaches that could limit their options in the case of a downturn or sudden crisis. Managers who remain focused on maintaining their investing “style” (for example, value investing, growth at a reasonable price (GARP), or others) in the face of rapidly changing market conditions may lack the flexibility or robust planning capabilities necessary to provide genuine downside protection for clients.

3. Track record of establishing pre-determined exit points—and sticking to them. At the level of the individual securities in a portfolio, knowing when to sell, what to shift to, and why can be just as important as knowing what to buy in the first place. Financial advisors can identify strong potential TAMP partners in this area by examining the triggers and pre-determined exit points they use to determine when to cut losses or harvest gains.
 

How have they established these guidelines? Are they driven by a rational, emotion-free process, or do they rely on the manager’s gut instincts? How do they differ for the various demographics the TAMP seeks to serve or objectives it hopes to accomplish? Equally vital, advisors should ask potential TAMP partners for evidence of their track record in adhering to these exit points, since establishing collars and guardrails does no good if the managers habitually overrule them in times of stress.
 

Choosing the right TAMP partner can accelerate an advisor’s growth and efficiency by providing access to sophisticated investment expertise while taking time-consuming portfolio management functions off their plate. Given the recent profusion of TAMP offerings, however, the decision to go this route also introduces substantial complexity.

In seeking the best investment solutions for their clients, it is incumbent on financial advisors to dig deeper into each potential TAMP partner’s approach to asset allocation, as well as their risk management strategy and capabilities. Only by performing this in-depth due diligence can advisors hope to position their clients to achieve their financial goals while minimizing the impact of the next market shakeup, whatever form that event may take.

Greg Luken is founder and CEO of Luken Investment Analytics, a turnkey quantitative research and asset management firm that enables financial advisors to deliver innovative asset allocation strategies to retail investors. He can be reached at [email protected].