Risk is the two-horned dilemma of financial advice. On one side, risk is the reason people need financial advisors—if Treasury bonds were paying 10% yields, few people would need financial help. Yes, they’d also need insurance assessments, cash-flow management and tax mitigation, but as financial planners discovered in the 1980s, nobody will pay you 100 basis points for those services.
Of course, default risk and inflation would eat into those “risk-free” returns and bond values, but few retail investors are sophisticated enough to think about those things. That brings us to the other prong of the risk conundrum. Because most people don’t understand investment risk, risk management is hard to sell and even harder to keep clients focused on.
I know that some advisors, broker-dealers and asset managers have developed programs to help clients better understand risk and “stay the course” during market downturns—and that some of them are quite good. But as far as I can tell, the word hasn’t gotten out to the majority of advisors’ clients. It doesn’t help that academic views of risk differ greatly from the way normal people see risk. For typical advisory clients, there’s really only one risk: losing their hard-earned money. That’s why, in their heart of hearts, most clients are looking to their advisors to take their money out of the market before it goes down.
There’s a potentially greater risk to investors than bailing at the wrong time, and it’s not covered by most risk education programs: high investment costs. Markets and portfolios may go up and down, but fees and loads are constant and forever (even the impact of a one-time, up-front load will be felt throughout the life of an investment). In my view, the primary job of a professional financial advisor is to mitigate these costs.
For 22 years, starting with the Reagan bull market (which really took off in 1982, but didn’t catch the attention of advisors until ‘86 or so), well-allocated, buy-and-hold portfolios were the risk management tool of choice for retail advisors and their clients. The prevailing theory was that by diversifying holdings over low-correlating asset classes, investors could consistently capture attractive returns over time. Many did, even with the market “correction” of 1991 and the dot-com crash of 2001.
All of that changed in September 2008, though, when virtually all asset classes (except Treasuries) took a nosedive at the same time, and advisors and investors alike were painfully confronted by the fact that the markets had changed, linking asset classes through leverage, globalization, packaged products and programmed trading. Consequently, traditional asset allocation has largely gone the way of parachute pants, fax machines and Donkey Kong, and have been replaced by demand for a new, higher level of risk management.
Not surprisingly, the new wave of risk management portfolio solutions has been provided courtesy of today’s leading-edge technology, which enables the creation and management of highly diversified, low-cost investment vehicles (like ETFs) and risk assessment models that can collate and analyze risk factors on a scale that has never before been possible. Innealta Capital in Austin, Texas, is one of a handful of firms that has successfully combined the broad diversification of asset classes available in today’s ETFs with risk management computer modeling to create investment portfolios with significantly reduced risk and substantially increased returns. In fact, Innealta’s low-cost portfolios may well be the next generation of managing risk in client portfolios.
Innealta is well-aware of its role in today’s advisor-managed portfolios, providing contact and the flow of information as a major part of its advisor relationships. “In the new investment climate, advisors have closed their ranks on money managers. Advisors who used to use 12 or 15 managers now want deeper relationships with a small number of managers, so we provide a ton more data to the advisors we work with,” said CEO Jeff Montgomery.
Montgomery added that Innealta provides its retail advisors with the same RFP quarterly due diligence as its institutional clients. “Even if they are with big brokerage firms, they want to know more than traditional disclosures. Not only are E&O carriers looking for more accountability in portfolio management and denying coverage if they don’t find it, but more and more advisors understand that if the money management goes bad, there’s really nothing else that matters.”