From the June 2004 issue of Investment Advisor • Subscribe!

THE GLUCK REPORT- The Right Way To Optimize

Portfolio Parade

Is today's "sophisticated" advisor actually that sophisticated after all? A growing number of academics and leading investment thinkers believe they are not.

Some, like Bill Jahnke and Peter Bernstein, criticize methods commonly used by advisors. These folks eschew econometric modeling and mean variance optimization to build portfolios in favor of fundamental analysis relying on GDP growth, the yield curve, corporate earnings growth, and matching investments to needed cash flows. Other leading thinkers, like Roger Ibbotson and Mark Kritzman, rely on optimizers and econometrics. But they say it is common for advisors to misuse these methods, and add that advisors who don't use econometrics and optimizers at all are basically guessing about investments with other people's money.

No matter which side is right, advisors don't look so smart in the eyes of the great thinkers of our time. The pro-optimization believers like Ibbotson and Kritzman say advisors using optimization to create model portfolios or individual client portfolios often do it wrong and misapply the tool. Not using optimization is tantamount to guessing, in their view. Then there are opponents of optimizers, like Jahnke. He says portfolios should be matched against long-term client goals and the cash flows needed to fund them, not optimized for a one-year risk and return horizon.

Take the typical sophisticated advisor's approach to giving investment advice. When a client walks in the door, she is given a questionnaire asking about assets, income, and debts. Then to assess risk tolerance, the client fills out a questionnaire asking how she feels about skydiving and motorcycle riding.

Then, the sophisticated advisor takes a model portfolio he has built or that he has assembled in his mind, and customizes it to the client's individual needs. If the advisor is really sophisticated, he shows his client an efficient frontier--a continuum of portfolios trading off annualized standard deviation for annualized return--and picks the best asset mix given that particular client's acceptable risk level.

Armed with the asset class breakdown, the advisor then selects particular investment vehicles--stocks, bonds, mutual funds, ETFs, annuities, and other pro-ducts--to fulfill the optimized asset mix picked for that client.

According to the brightest financial minds of our day, practicing this way raises lots of questions. Some of the big ones:

o When you use a risk tolerance questionnaire to select a point on the efficient frontier for your client, what does skydiving have to do with his ability to tolerate risk? Should you be relying on these proxies for risk and accept that they are reliable?

o Should you be so focused on figuring out a client's aversion to short-term volatility--one year's standard deviation--when the client is trying to fund a long-term goal?

o What effort was made to ensure the inputs in your optimizer are smart?

o Have you thought about weighting your predictions for expected returns on specific assets against history while factoring in how confident you are about your prediction, or using optimization software that does this calculation for you?

o Are your return and standard deviation inputs based on history when they're really supposed to be based on expected returns

o When telling a client about the optimization process, do you explain that the point you pick on the efficient frontier for his portfolio is a crude estimation of the future and far from scientific?

o Have you used software tools to show yourself and your clients that there are many efficient frontiers that might allow them to reach their goals?

o Rather than using a risk tolerance questionnaire to select a single point on the efficient frontier for a client's asset allocation, should you perhaps be using software to find the precise point on the efficient frontier that is most likely to help a client reach his goals?

Having spent the better part of two weeks researching new enhancements to optimizers and speaking with the people researching and writing in scholarly investment journals about cutting-edge techniques, I'm now certain of two facts. First, I'm not smart enough to tell you whether Roger Ibbotson, Dick Purcell, Mark Kritzman, or Bill Jahnke are right about their respective approaches to using an optimizer, building a better optimizer, and applying historical returns to predict the future. It's kind of like religion, and only you can decide who's found the right answer.

Second and more important, there is another world of investing out there that financial planners and most other independent investment advisors are not living in and don't know about. It is a world that looks down at most of the work done by independent advisors as crude, naive, and misguided. It is a world of ideas and tools that independent advisors have ignored, been too frugal to consider, or, perhaps, found too complex and new. But these new ideas and tools are bound to come your way over the next few years. If you choose not to learn about them, your competitors may soon learn to build better portfolios than you do, and your business could suffer.

Optimizer Demos

Two companies that make enhanced optimizers hosted Web demonstrations at my request: Ibbotson Associates, a respected advisor toolmaker based in Chicago, and PlanScan, a tiny company out of Boulder, Colorado.

Let's look first at Ibbotson's new tool for resampling. To be honest, it's not all that new, having been introduced as the major new enhancement to Ibbotson's EnCorr suite of products a little over a year ago. EnCorr is Ibbotson's institutional-strength analytics software package. It is mostly used by pension funds, banks, money managers, and other professional investors, along with a small number of advisors willing to plunk down the $10,000 to $15,000 annual licensing fee. However, Ibbotson does sell a trimmed-down version of this optimizer program with its resampling engine for a more reasonable $5,000 (currently discounted to $4,000), plus an annual $4,000 license fee.

Resampling, according to Ibbotson Research Director Peng Chen, has been around for years in the academic world. But it has pretty much been ignored among professional investors. It required too much computing power until the advent of speedier processors in the last few years made it possible to run resampled portfolios. "Resampling is a systematic way to account for the potential estimation error in the inputs you use for mean variance optimization," he says. MVO requires forward-looking returns. Historical returns provide only a sample for estimating forward-looking returns. This creates room for error.

Many advisors gave up using optimizers in recent years because they relied so much on history and saw their optimizers as nothing more than a fancy rear-view mirror. Others who use MVO rely heavily or completely on historical returns and standard deviations for their inputs.

Mark Kritzman of Windham Capital Management in Boston, has pointed out that Harry Markowitz, who won the Nobel Prize in economics in 1990 for work outlined in his groundbreaking 1952 article, "Portfolio Selection," said from the very start that he used expected and not historical returns for his optimization inputs.

The means and variances plugged into an optimizer can be guided by history but require judgment about the future, and expected returns. But Chen points out that the trouble with using expected returns is that we don't know the future. The past only provides a sample of all the possible returns, simply because it cannot include the future. To manage this "estimation error" inherent in your inputs, Ibbotson's optimizer resamples an efficient frontier using Monte Carlo simulation. Instead of relying on a single efficient frontier as an illustration of your possible portfolios, Ibbotson's software lets you randomize the returns to see 150, 250, or more, efficient frontiers around your original one. It creates an average efficient frontier based on the many simulations. The result is a portfolio that tends to be better diversified and that won't need to be constrained to avoid dominance by any one asset class.

Another Option

The other tool to enhance optimization comes from Dick Purcell. An out-of-the-box thinker, Purcell spent his career writing and teaching CPAs about finance after graduating from MIT and Harvard. Purcell, a fiery critic of the education and training for CFPs, has programmed optimization software that runs Monte Carlo simulations all along an efficient frontier to find the optimal portfolio on the frontier for achieving a client's goals. Instead of focusing on the probability of achieving an annualized return at a given level of risk, Purcell's Portfolio Pathfinder software can show clients the likelihood that a portfolio will allow them to achieve their long-term goals. "An efficient frontier graph tells us nothing about where along the curve a client portfolio should be," says Purcell. "It tells us nothing about which portfolio is better and which is worse for helping a client achieve his long-term goals."

Purcell says the current method for choosing a point on the efficient frontier for a client is administering a risk-tolerance questionnaire, which he calls nonsense. "There are 141 topics in the CFP investment education module, and not one of them addresses how to find the best portfolio for your future dollar goals," says Purcell, who taught about business graphics for the American Institute of CPAs for many years and authored Understanding a Company's Finances--A Graphic Approach, for Houghton Mifflin in the early 1970s. "Instead, thousands of CFPs are trained on a curriculum foisted on them by more than 200 universities that diverts attention from lifetime goals to single-year volatility and returns."

Purcell says that making a decision about which portfolio a client should get based on a one-year standard deviation versus return payoff ignores the benefits of long-term compounding on investments. "For example, at a rate of 10%, compared to the gain over 10 years, the gain over 20 years is over 3.5 times as great," he says. "For this reason, increases in expected return rate that appear very small on the single-year efficient frontier produce far larger increases in expected long-term return. To see this advantage, you have to move beyond the efficient frontier's single-year view, to compare the portfolios in a long-term compound return."

By running a Monte Carlo simulation on a range of 12 or so points covering the efficient frontier, the client can see the likelihood of meeting his goals over his lifetime by using one portfolio versus another. Purcell says this is a critical difference from the way optimizers are currently used because it shows the client that one portfolio on the frontier is likely to bring him closer to achieving his long-term goals than another portfolio on the efficient frontier. In addition, it shows the client the optimal portfolio over the long term, taking into consideration the effects of compounding and shrinking deviations on asset classes over the long haul. Purcell's software is based on using ETFs and index funds to fulfill portfolios because they can be true to the optimization of the asset classes.

Things are heating up on the portfolio management front at Fidelity Institutional and Schwab Institutional. Fidelity has signed a deal with a portfolio accounting and performance reporting software company that is already a big player in the institutional asset management business. Schwab, meanwhile, is releasing the long-delayed SQL version of its Centerpiece software.

Fidelity's deal is with Los Angeles-based Integrated Decision Systems, which was founded in 1981 and has been serving the wrap account, prime brokerage, and asset management units of large brokerages including UBS, Morgan Stanley, and A.G. Edwards. It is also the performance reporting system for the retail version of Fidelity's Portfolio Advisory Services program.

IDS claims $4 trillion of assets on its system, but until the Fidelity deal did not serve RIAs. Schwab's former chief of technology marketing, Ron Lovetri, who was laid off by the discount broker two years ago amid massive bear-market cutbacks, has been hired by IDS to run the marketing program.

Lovetri says IDS "would not know what to do" if RIAs individually called to buy the IDS reporting solution. IDS, at least for now, will serve the RIA market solely through Fidelity, he says. However, Lovetri says the deal with Fidelity is not exclusive and IDS in time is likely to open the product to RIAs who do not work with the Boston-based company.

Pat Jancsy, a Fidelity senior VP who is in charge of advisor technology solutions, says the IDS product will be sold as a Web-based application and will be integrated into Fidelity's brokerage platform. The advantage of a Web-based solution is that advisors don't have to touch their data as much. You make a trade on a Web-based application provided by IDS and it gets sent to the custodian, allowing your reporting solution as well as the custodian to account for the transaction.

IDS will download and reconcile all the data for advisors from Fidelity and other custodians. Lovetri says it already has a Schwab interface. Links to other custodians and brokerages cannot be far off. But the disadvantage of a Web-based portfolio reporting solution is that the data is not in your office. Independent advisors have been slow to adopt Web reporting solutions because the account data is the lifeblood of their business, and they fear being dependent on a third party.

Portfolio 2000 and Advent's Web-based outsourced reporting system have not attracted a significant number of advisors, and most RIA firms continue to use desktop versions of Advent Axys, Centerpiece, and dbCAMS rather than switch to the newer Web products. While the low adoption rate can be partially attributed to the fact that Web-based applications are still relatively new and advisors are slow to adopt untested solutions, the lack of interest in these portfolio reporting applications may have as much to do with fears that Advent and Schwab could raise prices or leave the advisors feeling too dependent on these large companies.

Third-Party Solution

Fidelity has emphasized that it is not the provider of the IDS product. According to Jancsy, the advisor's contract for the reporting system will be with IDS. In addition, Fidelity says that advisors will be able to download their account data daily or monthly into a file that can be imported into any database product, such as Microsoft SQL or Excel. Jancsy says the data can also be imported into financial planning applications. "Advisors want access to their data and that's why we were attracted to IDS," Jancsy adds. "They figured it out, and they know that advisors were not comfortable relying on their custodian or another third party to have access to their data without the advisor having access locally themselves."

In cutting a deal with IDS, Fidelity will bring its RIAs a Web-based accounting solution that will free them from downloading and scrubbing their data daily, a time- and money-saver. This could pose an issue for Schwab. Based on my conversations with advisors over the years, many simply do not feel comfortable with all their client account data on a server owned by their custodian.

TD Waterhouse Institutional, which also custodies assets for RIAs, already offers a Web-based portfolio accounting solution in partnership with Advent that is similar to what Fidelity is offering with IDS. While the Waterhouse program has had some success, many advisors are squeamish about handing all their data over to Advent because of its reputation for high prices, and because it is a proprietary database that does not cleanly export data to other applications.

Schwab's SQL

This brings us to the significance of Schwab's impending release of the SQL version of Centerpiece's successor, PortfolioCenter. SQL is an open database, allowing advisors to import and export data into applications for custom reporting, financial planning, analytics, and more.

Jim Starcev of Etelligent Consulting in Kansas City, a Centerpiece service bureau, was one of 20 beta testers of the new Schwab Performance Technologies product and recently completed converting a huge database from Centerpiece to PortfolioCenter. The database was for a firm with $1.5 billion in assets at five custodians. It has 20 advisors with 50 billing systems, and it provides each client with 10 reports. Starcev says his firm began the database conversion on a Friday night and it ran for 53 hours straight. The following Monday, the conversion completed without timing out or crashing.

Starcev says the new PortfolioCenter processes reports two to three times faster but its look and feel is nearly identical to the old version. Your staff won't need to spend any time being trained to run the new product. In terms of functionality, the new product offers little new, however. There are no new fixed-income capabilities or graphics. The one significant new enhancement has been in security. Until now, Centerpiece did not require you to log in with a user name and password. PortfolioCenter does. In fact, it gives a firm the ability to allow some staffers more rights than others. So you could enable some people on your staff to view reports, for instance, but not change the database. "As people look at our development efforts and what we focused on and what we delivered, I think they will see clearly that we have focused on open architecture," says Dan Skiles, a vice president at Schwab. "We have 40-plus interfaces to different custodians and brokerages, we have added the DTC interface in the last two years, we are always adding more interfaces, and now we have gone to SQL, an open architecture platform. Everything we have done supports the open architecture stand we have taken."

Advisors who have not purchased a computer or server in the last 18 months may need to buy one to run the new product. You'll need a server or PC with at least a 2.4 GHz processor to run the program. To see if you will need new hardware, you can go to www.schwabpt.com/products/system/.

For Most, No SQL License

Happily, Skiles says only about 10% of the 3,000 offices running Centerpiece will have to purchase their own SQL Server licenses. The product ships with Microsoft Data Engine, which generally should be adequate for firms with six or fewer users using the database simultaneously, and less then two gigabytes of data. He adds that firms that go beyond either of these two limits may suffer slow performance and want to buy their own SQL Server database license, which will cost about $2,000, to enhance performance.

The upgrade is expected to start this September and take one year to complete. If your Centerpiece license expires in September, you should receive the new PortfolioCenter software. If your renewal occurs in August, you'll have to wait 11 months to get the new software.

What about the price? "We have not made any pricing decisions," says Skiles. "I will tell you, though, we have not raised our prices in over four years. We are always looking at pricing as related to what we are delivering and what the competition is."

Here are Skiles' answers to my questions on Schwab's intentions regarding its portfolio management offerings.

Will you continue giving away licenses to Schwab PortfolioCenter users who are Schwab Institutional customers? We really don't give it away today. We always look at the overall relationship, with what the advisor is doing with us.

What asset level do you need to have to qualify for that program? We have nothing specific on that. We look at the overall relationship.

Three years ago, you said you would not sell Centerpiece to an advisor unless he or she was a Schwab Institutional customer. Is that still the policy? Let me be clear on the policy and clear up any confusion that was around when that was announced. We have a sales staff of less than 10 people focused on selling PortfolioCenter. Their focus is the 5,000-plus Schwab Institutional clients. If someone calls us who does not have any business with Schwab Institutional and says, "I want your product, and I don't need to be convinced," and they are ready to purchase the product, then we will sell to them. But we will not go out to their office and actually sell. We can't, because of our limited resources.

So you will sell to non-Schwab advisors? Yes.

So was there a change in the policy from what it was three years ago? I won't say there was a change. There was a lot of confusion at that time.

Schwab for years made a point of emphasizing that Performance Technology Inc., which makes Centerpiece, was independent and autonomous. Three years ago, you changed the name of the software and the name of PTI to include the Schwab name. That has made some advisors using Centerpiece worry that you were creeping toward making it proprietary, which could somehow restrict their independence. We believe in open architecture. The Schwab brand is a strong brand and we wanted to strengthen the Performance Technology brand. We also wanted to represent the amount of investment Schwab has made to the product suite. That was part of the decision in adding "Schwab" back into to the product name, to let people know it is not just a simple technology company out of Raleigh, North Carolina. There is a Schwab technology company providing resources that strengthen the overall product suite and the brand.

The changes in branding and sales policies occurred shortly after Schwab switched responsibility for who runs PTI from the head of institutional technology to the head of marketing. Who runs PTI now? The development team reports to the head of Schwab technology for the institutional division. The operation and marketing staff at PTI report to the head of our Schwab Institutional marketing area. The sales/relationship-management staff reports to the head of sales/relationship-management at Schwab Institutional. The tech support people report to the head of our service team at Schwab Institutional.

For the most part, it has been that way now for over two years.

Schwab PortfolioCenter interfaces with many custodians other than Schwab Institutional. Are there any plans to change that? No. Absolutely not. We have 40-plus interfaces and are always adding more.

For many advisors, trust has become a key issue in dealing with Schwab. Why should advisors take your word for it when you say that they can continue to use Schwab PortfolioCenter without worrying about Schwab Institutional trying to use it as a lever? Look at what we accomplished with SQL, where we are going with the product, and see where we are putting our money, where we are spending our development dollars.

This software is about two years late. Why did it take so long for a big company like Schwab to get to this point? It was a very complicated process. We dealt with over 4 million lines of code, so we were touching a lot of areas of the product to get it to an SQL version. It did take longer than we thought it would take. During the whole process our clients were telling us, "Get it right, make sure it works well, and do not ship it when it is not ready."

During this time frame, we did release a new version. In January, the 5.6 release took care of the tax law changes that were approved by Congress and the President back in the middle of last year, and no one could have predicted that. So we needed to make modifications to the old Centerpiece program during our development efforts, which obviously affected the timing.

What are you doing about the Web-based version of the product that you announced you would be building three years ago? You canceled the release of it last year. What is the new release date? The status is still the same. We are not actually working on it. We focused our development resources on the release of the SQL version for the desktop. We surveyed our clients, talked to them, and a lot of clients told us that was important to them. That is where we focused all our attention. As it stands now, that product--the outsourced product--is still a possibility. But there is no active development going on right now. We are going to roll out PortfolioCenter for the desktop and then determine whether we need to continue development on the outsource solution by asking clients, finding out if there is demand.

Tell me about your positioning versus Advent Axys, your main competitor. At Schwab, we have a lot of customers on both products, and customers are happy. Our goal is to make sure they are picking the right product. With Schwab PortfolioCenter, I would say the scalability and open architecture is the big deal clients have been asking for. We were happy to finally get it out there for them.

Editor-at-Large Andrew Gluck, a veteran personal finance reporter, is president of Advisor Products Inc. (www.advisorproducts.com), which creates client newsletters and Web sites for advisors. Advisor Products may compete or do business with companies mentioned in this column. Gluck can be reached at agluck@advisorproducts.com.

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