Regulators don’t understand diversification

This article was originally published in October 2013.

In all professional sports, managers take a disproportionate share of criticism when things don’t work out—and with good reason. They’re responsible for assembling players with the expectation of winning games.

Clients have similar expectations of investment advisors, who are supposed to assemble products into winning portfolios. But rules and misguided interpretations sometimes get in their way.

The suitability standard is one example. Advisors must assess suitability pursuant to NI 31-103. The key principles are to know clients’ needs and objectives and other factors relating to a purchase or sale (KYC), as well as each product’s attributes and associated risks (KYP). Trading off higher returns for more protection is the challenge for advisors, just as building a balance between offence and defence is for hockey coaches.

In fact, hockey has many parallels to the investment world. Forwards take risks to penetrate the offensive zone, and are exposed to bruising body checks at the blue line. Riskier investments like technology, small cap or emerging equities perform these roles in portfolios.

Meanwhile, size, checking ability and aggressiveness are qualities of suitable defencemen. In the investment world, dividend-paying utilities, banks or preferred shares fall into this category because they provide relatively predictable re- turns. Net coverage and the ability to anchor a defence make for suitable goaltenders, just like fixed-income instruments that offer stable if unspectacular returns with predictable risk.

Six goaltenders

As a coach, would you put six goaltenders on the ice at the same time? Securities regulators would. According to them, an advisor should only recommend conservative investments to conservative investors. So investing 100% in Canada Savings Bonds would be suitable for these investors.

However, investors usually combine several securities, funds or ETFs. Portfolios deliver risk and return for investors, just as combinations of players provide the balance between offence and defence for a team. Some products with higher risks—limited liquidity, leverage or complexity—offer higher compensation, demanding intervention in the absence of a fiduciary standard. But suitability obligations, while laudable for considering conflicts of interest, lack insight beyond a single transaction.

An important goal of suitability is to protect investors from risk. The key to combating risk and volatility is diversification. As a result, pension plans, endowments and larger institutional accounts have expanded the number of asset classes they use. For instance, the Harvard Endowment once had a simple domestic stock, bond and cash portfolio. Today, its policy portfolio includes 13 asset classes.

What asset allocation and how much diversification is suitable? CSA Staff Notice 33-315—Suitability Obligation and Know Your Product, IIROC Notice 09-0087 and Best Practices for Product Due Diligence do not discuss diversification.

Consider that managed futures provide almost a perfect hedge for long-only portfolios. Since futures are used, this strategy is limited to aggressive retail investors. Regulators have not addressed that different assets and risks combine to provide superior risk dampening and return possibilities. Investors suffer as a result: Imagine not being able to put a superstar centre on the ice with a defensive winger, even if they play well together.

No special teams

Investment dealers have their own asset allocation standards.

A moderate portfolio may have a 60% equity and 40% bond weight, while a conservative one may have 40% equities and 60% bonds.

Again, it doesn’t seem as if regulators understand diversification. If an investor is assessed as having a moderate 60/40 profile and has RRSP, taxable, TSFA and RESP accounts, common sense suggests highly taxed assets, like bonds, should be placed in the RRSP. Loading a TSFA with riskier holdings takes advantage of that structure, yet each account must now have a 60/40 mix.

How suitable is the suitability obligation? If the Toronto Maple Leafs had to comply with securities regulations, they could only play six goalies, six defensemen or six forwards at the same time, and have no power plays or penalty-killing specialty lines. Regulations are about fairness and controlling abuse, but not about winning. That’s crazy—even for the Leafs.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.