This article appears in the November 2021 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.
Securities regulators aim to protect investors, not improve their investment outcomes. But know-your-client (KYC) risk assessments and product risk ratings can actually have a negative effect on portfolio construction and investor outcomes.
In performing KYC, firms must classify an investor as conservative, moderate or aggressive (or shades in between). But risk tolerance is not static — conservative investors can be emboldened during bull markets — and life goals come with different timelines and priorities. Similarly, products must be rated by the advisor’s firm or an independent third party. For the most part, conservative investors are matched with conservative products. But the two main portfolio construction approaches — modern portfolio theory (MPT) and goals-based — can be at odds with a pigeon-holed risk tolerance.
How compliance constrains MPT portfolios
Regulations require that products and portfolios align with the investor’s risk rating. I know one firm that insisted each client account (regardless of tax status) be invested in products matching the investor’s risk profile and that all accounts were to have identical asset mixes. While that made the compliance job easy, clients were the losers. Overlooking an account’s tax advantages forced advisors to construct suboptimal portfolios. And by restricting riskier assets to 15% of the portfolio, clients were denied potentially more effective diversification.
Compounding the problem, rebalancing to a prescribed asset mix disregards market volatility and can expose clients to extreme risk above the 12.5% long-term standard deviation of a 60:40 portfolio (based on the S&P 500 and U.S. aggregate bonds). Prior to the 2000 tech crash and the 2008 global financial crisis, the 60:40 portfolio’s volatility spiked to more than 40%. If regulators were serious about protecting investors, they would mandate rebalancing to the long-term standard deviation of the 60:40 portfolio — not its asset mix.
How compliance constrains goals-based portfolios
Goals-based strategies typically use two portfolios: one safety (Safety 5) and one growth (Growth 24 —see Table 1). Theoretically, an investor with a conservative risk tolerance must save more to offset lower portfolio risk. The safety portfolio is a near-cash fund to meet goals with time horizons of less than five years, meaning 75% fixed income and 25% equity.
The compliance problem comes with the growth portfolio. It has a time horizon of 24 years, with 83.6% equities, and is more conservative than normal because of elevated market volatility. There is a 95% probability that the portfolio will, at minimum, return capital plus inflation, and a 99% probability that drawdowns during any 12-month period will not exceed 24%.
Table 1: Examples of goals-based ETF portfolios
|Asset class||Potential ETFs||Safety 5||Growth 24|
|Short-term bonds||VSB, ZCS, XSH||46.5%|
|Corporate bonds||VCB, ZCB, HAB||38.5%||16.4%|
|U.S. equities||XUS, ZSP, HXS||24.2%|
|U.S. equity low vol||ZLU, XMU, ULV||8.7%|
|Canadian equities||XIC, ZCN, HXT||28.5%|
|Canadian equity low vol||ZLB||6.3%|
|International equities||XEF, ZEA, VIU||18.5%|
|NASDAQ||XQQ, HXQ, ZQQ||12.4%|
Yet a conservative investor owning the Growth 24 portfolio might raise compliance concerns. Table 2 shows a goals-based solution for a 40-year-old investor with $1 million. Only 15% of her portfolio is due within five years and 85% is more than five years away.
Table 2: Sample goals-based client
|Senior care||45 (essential)||$100,000||$350,000|
This client has 85% in growth and 15% in safety. This would put 83.3% of her overall asset mix in equities. If her KYC profile pegged her as moderate or conservative, compliance would demand immediate de-risking.
Mandating a fiduciary standard would be a simpler way to align investor and advisor interests, but politics is more powerful than common sense. The industry and regulatory obsession with risk ratings for both clients and products can force advisors to make suboptimal choices. Passive (or lazy) compliance departments that force rigidities are dangerous to investor well-being.
The only performance that should matter to investors is achieving their financial goals on time. Regulators need to recognize that achieving goals requires more latitude than compliance manuals allow. Too few advisors and compliance officers are willing to fight for their clients, but more should.
Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.