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The Investment Process
WELCOME TO
PEN-LIFE INVESTMENT MANAGEMENT
We are pleased to welcome you into a new era of asset management at Pen-Life. Technological and analytical advances within the financial industry means we are now able to offer a more comprehensive and robust investment management service to our clients than ever before.
This introductory document outlines the service we offer, its management, and how the Pen-Life Risk Rated Portfolios work.
· What is Pen-Life Investment Management?
· How Do We Implement Changes?
· What Do We Expect From The Client?
· What Does This Service Cost?
We hope that you will find these documents comprehensive and clear, but as always if you have any queries we will be happy to resolve them.
WHAT IS PEN LIFE INVESTMENT MANAGEMENT?
Over the last 10 years or so, Pen-Life have been using electronic dealing platforms such as Skandia and Cofunds for our clients to great effect. There is a wealth of evidence which suggests that asset allocation is the key determinant in portfolio performance, and our experience over the years supports this. Asset Allocation means determining the proportions of monies to be held in such things as commercial property, government gilts, UK equities, overseas equities etc, in accordance with an individual's attitude to risk. Evidence would suggest that the selection of the individual funds within these components is of secondary importance, contrary to popular belief.
Over the years we have seen for ourselves the effect of asset allocation for our clients and the real benefits which have been produced. However the management of such portfolios has proven to be time consuming and cumbersome, which has had a massive impact on costs. This, together with the logistics of managing thousands of clients' individual portfolios with thousand of different funds, led us to devise a more robust and sustainable investment process.
To make the investments more manageable, and our service more consistent, we have taken some time to develop a slightly different strategy, still using the asset allocation model and risk profiling, but creating several different portfolios covering our clients' tolerance to risk, and we have made the resulting portfolios available across several trading platforms (also known as "wraps”.)
An additional benefit of this strategy is that, as we will be regularly monitoring these portfolios, should a fund manager leave or if there have been substantial changes in the investment performance and the fund no longer meets our selection criteria, we are able to recommend a fund switch to all of our clients invested in that portfolio in a speedy and efficient manner, which is simply not possible at the moment, except on an ad hoc basis or during a client's periodic review.
A further advantage is that, as a client gets closer to a specified goal or stage of life, such as retirement, they may very well decide that they wish to take a lower (or higher) level of investment risk, which can be quickly and easily effected on the platforms. The decision to develop these portfolios was driven by a desire to improve the service we offer our clients, to add real value to that service, and to attempt to improve investment returns without increasing risk.
The saying "don't put all your eggs in one basket” is fundamental to successful long term investment management. Different investments tend to rise and fall in value at different times. A well diversified portfolio takes advantage of these peaks and troughs, reducing the risk of loss, and producing steady growth over the medium to longer term.
Asset allocation is the science (or art) of diversifying a portfolio optimally. Diversification can be achieved through asset class (stocks, bonds, property, cash, etc.), geographic (different stock markets), sectorial (over different industries) or by other factors such as between small and large cap stocks or ‘value' and ‘growth' stocks and/or management style.
Why is Asset Allocation Important?
There have been numerous studies into this area of investment management. When Brinson, Hood & Beebower (1986) published their paper "Determinants of Portfolio Performance”, their results were startling. Their paper attempted to understand the relative importance of various factors on the performance of a portfolio. The factors considered were asset allocation, stock selection and market timing. Asset allocation in this study meant the relative holdings in cash, bonds and equities.
The results showed that the overwhelming factor in the determination of portfolio performance was the asset allocation of the portfolio. Even picking the best stocks or timing the market correctly would only account for a small fraction of a portfolios performance. This study, and others like it, has shown investors the importance of optimal asset allocation within their portfolios.
Factors contributing to portfolio performance
Source: Financial Analysts Journal, July-August 1986
An important point of note: You will notice that the word ‘performance' has been used in the above explanation. By ‘performance' we do not mean ‘growth', but rather the variation of returns or risk.
This is a fundamental point and one that many large investment institutions do not fully understand. The studies often quoted state that over 90% of the variance of investment ‘returns' in attributable to asset allocation.
These studies are actually saying that diversifying across different asset classes, significantly reduces the variance or volatility of a portfolio and is quite different from saying that diversification necessarily leads to increased returns. Using the word ‘return' or ‘growth' in this context is incorrect and misleading. However, a portfolio with reduced risk (through diversification) could then allow higher risk elements to be added to the portfolio, possibly increasing growth for the same level of the original risk.
What is Modern Portfolio Theory?
In the early 1950's, Harry Markowitz published a thesis. This formed the basis of what has come to be known as ‘Modern Portfolio Theory'. Markowitz won a Nobel Prize in 1990 for his work in this area. His ideas looked at finding an optimal balance between investment risk and reward.
Taking risk to mean the variation of returns, Markowitz's proposal was that rather than considering the risks of individual stocks in a portfolio, that the risk of a portfolio should be look at as a whole. Markowitz argued that it should be possible for a high risk (high reward) stock to be added to a portfolio and actually reduce the risk of the portfolio as a whole.
This comes back to the idea of correlation or the ways stocks (or funds) move in relation to one another. It is not true to say that a portfolio of risky (high variance) funds will necessarily be high risk as it depends of the so called ‘correlation co-efficient'. This is a term to describe how funds move in relation to one another. An ideal portfolio will have a number of funds, that are negatively correlated, meaning they tend to rise while others are falling and vice versa. This allows high risk (high growth) funds to be used whilst not increasing the overall risk or variance of the portfolio as in the example below.
How negatively correlated funds reduce risk
The Efficient Frontier
‘Optimal' or ‘efficient' portfolios are theoretical concepts and are achieved when a portfolio is established where a maximum mathematical return for a given level of risk has been established. In order to determine these efficient portfolios it is necessary to analyse every combination of assets and plot the expected risk-return outcome for each combination. The optimal or efficient portfolios are then defined as those that maximise the expected return for the desired level of risk. This is illustrated in the diagram below.
Having established the expected outcomes for all the combinations of assets, a line can be drawn to join up each of the optimal portfolios at each risk level; this line is known as the Efficient Frontier.
There are no portfolios with better theoretical risk-return profiles than those plotted on the Efficient Frontier.
It's clear that for any given value of standard deviation (risk), you would like to choose a portfolio that gives you the greatest possible rate of return; so you always want a portfolio that lies up along the efficient frontier, rather than lower down, in the interior of the region. This is the first important property of the efficient frontier: it's where the best portfolios are.
The second important property of the efficient frontier is that it's curved, not straight. This is actually significant - in fact, it's the key to how diversification lets you improve your reward-to-risk ratio. To see why, imagine a 50/50 allocation between just two securities (or funds). Assuming that the year-to-year performance of these two securities is not perfectly in sync - that is, assuming that the great years and the poor years for Security 1 don't correspond perfectly to the great years and poor years for Security 2, but that their cycles are at least a little off - then the standard deviation of the 50/50 allocation will be less than the average of the standard deviations of the two securities separately. Graphically, this stretches the possible allocations to the left of the straight line joining the two securities.
The Efficient Frontier Optimisation
The Advantages of Regular Rebalancing
Rebalancing (reverting a portfolio back to its original weighting) regularly can have significant advantages. Over time, some holdings will outperform others and the portfolio will become out of line with the initial optimal position. By rebalancing regularly, not only are the investments kept in line with the initial investment needs, but some existing assets are sold that have risen in price (locking in some gains) and some new assets are bought at a lower price than previously. This can have significant advantages in terms of long term risk/reward trade off positions. The chart below shows a static portfolio (left) against a regularly rebalanced portfolio (right). You can see that the rebalanced portfolio has a higher overall return and lower risk:
How Rebalancing Can Improve A Portfolio
Source: MPI Stylus, 12/31/04. The example above is based on a hypothetical portfolio consisting of 60% S&P 500 Index, an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance, and 40% Lehman Brothers Government/Credit Index, which is composed of the Lehman Brothers Government Bond Index and the Lehman Brothers Credit Index. The portfolio that was regularly rebalanced was done so quarterly throughout the 20-year period. The indices are unmanaged and do not charge fees or expenses. An investment cannot be made directly into an index. Diversification and Rebalancing do not ensure gains or prevent losses from occurring in a portfolio or account.
In light of the range of increasingly complex and numerous investment funds and strategies, Pen-Life have developed a range of portfolios, available across several trading platforms, designed to meet our clients' attitude to risk. The portfolios – The Pen-Life Cautious, Cautious Plus, Balanced, Balanced Plus, Speculative and Ultra Speculative Portfolios – are reviewed and reported on on a quarterly basis. In addition we have a natural income producing Portfolio (Pen-Life Balanced Income) and an ethical portfolio (Pen-Life Ethical).
The Portfolios
We have used Skandia's (OBSR) investment profiles as a guideline for the asset allocation when constructing our portfolios. However we believe these models are overweight in fixed interest, particularly in the bottom half of the risk scale. For this reason we have elected, from August 2010, to allocate a proportion of the fixed interest allocation to "Absolute Return” funds, some of which can be viewed as fixed interest alternatives in terms of risk but are designed to deliver growth regardless of market conditions.
We also feel that international equity needs to be included where possible, particularly in the income portfolio. Although it is historically difficult to generate dividends from overseas equities we believe that this is essential to risk management, and we have therefore included 2 funds which include large proportions of international equities whilst still maintaining an excellent track record for high dividend returns, also effective from the end of August 2010.
Active vs Passive Investment Management
One of the most fundamental and enduring investment debates is over active versus passive management. Which consistently offers the best returns over time? Which will ultimately provide investors with the best possibility of achieving financial goals?
Passive managers buy and hold portfolios that are designed to replicate the market, or a large proportion of it. By buying each stock in an index, or a broad representation of the stocks in an index, passive managers generally deliver returns that match their index, so in theory at least there will be no nasty surprises.
In contrast, active managers seek to build portfolios that outperform a market benchmark, usually through a combination of stock selection and market timing. In some years, some active managers will succeed in outperforming their benchmark, while others will fail.
Passive investing proponents argue that markets are efficient - that is, that the market takes into account all the available information about any particular security and price it accordingly. So they believe there is little room to take advantage of mispricing because prices already reflect true value.
But the proponents of active management argue that the market is not completely efficient, allowing smart investment managers to beat the market. And a number of managers clearly do so every year. But as the availability of information increases every year, say passive managers, so the efficiency will increase and it will become more difficult to beat the market.
Passive investors also cite the laws of arithmetic. It is a given that the average return of actively managed portfolios will equal the return of the market.
Passive advocates maintain it is impossible for the majority of investors to outperform the market so half of these funds should beat it and the other half should under perform it. Add in the costs of trading, administration and management fees, and fewer than half of actively managed funds can possibly beat the markets over time.
The key advantage of active management, the potential to beat the market, is only useful to individual investors if they consistently choose the winning managers. With no systematic, reliable way of ensuring that your choice of active manager will outperform the market, in the end you have to gamble on who you think will deliver the best returns.
It must be remembered that costs matter. Paying a total expense ratio of 2 or 3 per cent when equity returns are 6 per cent effectively wipes out the equity premium. This reinforces the need to choose managers who will outperform.
The costs of passive funds are low because the fund is not being "actively managed". But there is still an element of manager risk. Tracking methods vary, ranging from full replication - holding every stock in the index in proportion, to partial replication - holding a sample of the index, in order to reduce dealing costs. Timing of buying and selling can also affect performance. However, Passive funds are not as flexible as their active counterparts, and do not have star managers who can hop nimbly out of shares that look vulnerable in certain market conditions.
To be effective, actively managed funds have to be continually monitored.
In constructing our original managed portfolios, we adopted what we believed was an approach which captured the best of both worlds. Our "core” holdings were passive, which means that we captured market returns at very little cost. Our "satellite” holdings target fund managers who consistently deliver above average returns. And, of course, these are monitored on a quarterly basis.
However, our experience is showing that active management does bring more to the table than passive management, and we have gradually moved the emphasis of our managed funds to more active funds.
The Funds
Our investment criteria for fund selection can largely be broken down into 4 main stages of assessment:
- Cost - We look to achieve good value returns for our clients, and so we have elected to use some passive funds in of the largest equity sectors. Where possible we also look to avoid excessive annual management charges and any initial charges in our selection of managed funds.
- Financial Security - We are also aware that clients need to know that their fund managers are backed by large, stable investment houses, and for this reason we rely on fund ratings such as OBSR, S&P, and Crown ratings wherever possible, and also prefer to use funds with a history of at least 5 years, where practicable.
- Past Performance - We back test the few highest rated funds from a sector over 1, 3 & 5 years to make the most informed decision about the reliability of those funds in different market conditions.
- Composition – Our aim is not to rely on past performance as our sole driver in fund selection, so we also look at how a fund is made up to try to gauge how a fund might perform in the future. For example we may reject a global growth fund which relies too heavily on one geographical region, or an equity or property fund holding what we feel to be an excessive amount of cash.
The Investment Committee, headed by Julie Wilson, who is a Fellow of The Personal Finance Society and Chartered Financial Planner with over 30 years investment experience, review the portfolios on a quarterly basis to ensure the underlying funds are achieving the portfolio objectives, and investors are informed of any proposed changes before the portfolios are adjusted.
We believe that by employing these simple principles we can create a group of portfolio suited to a given level of investment risk required, which are cost effective, have a proven track record, and have an excellent risk reward balance over the medium to longer term.
Our Investment Committee is also dedicated to ensuring the ongoing improvement in streamlining processes and making this an exciting and rewarding proposition in which to invest, whilst ensuring that we remain staunch in our commitment to protecting our client's investments where possible and maintaining a high standard of service at all times.
Following our quarterly investment committee meetings, which take place in January, April, July & October, we write to every client invested in one of our pre-defined portfolios to inform them of the items discussed and any changes recommended as a result.
We have no authority, or desire, to make any changes to your investments without your consent and written authorisation. It is our duty to ensure, through frequent communication, that you fully understand the implications of any changes recommended, and it is of the utmost importance to us that you do not make any changes to your investments which you are not comfortable with or were not fully informed of. With this in mind, we will always send you an authority form with every quarterly mailing – in February, May, August and November – which you need to sign and return to us. Without your express authority we will not make the recommended changes (this in itself would have implications, detailed fully in the enclosed ‘What Do We Expect From The Client?)
Once we have your written authorisation we can action the fund switches, or rebalancing, online with no further paperwork required and at no additional cost to you.
What Do We Expect From The Client?
In order for the relationship between you and Pen-Life to function correctly there are a few key areas where we require your input, such as when your circumstances change, you require more income from your investments, or you require further clarification on a recommendation, but regarding our investment proposition in particular there is one key responsibility which we require you to fulfil.
When we carry out our quarterly investment committee meeting and issue you with a report on the recommendations we are making as a result, we require your written authority in order to action those recommendations. If you do not return the authority provided in the review letter we will not be able to action any changes to your portfolio until the next quarter, at the earliest, at which point we will send you another authority to sign. Continuous failure to return these forms will result in your asset allocation sliding wildly away from that recommended at outset and as a result you may find your investment subject to a much higher level of risk than you are comfortable with.
We will notify you of the time frame within which you must return each of the authority forms.
In all cases where assets are being placed on platform you will be issued with an illustration detailing the charges, which can be broken down as follows:
Platform Charges (Initial)
In many cases there will be a small fee charged by the product provider. This depends upon the specific wrap platform recommended, but, as stated previously, this will be explicitly stated in the illustration
Initial Fees (Up Front)
Clients transferring existing schemes, which we established, to a Wrap will be offered a discounted rate of initial fee in comparison with what we would ordinarily charge for new advice resulting in an investment in the Portfolios. This is because our aim is merely to cover the administration costs of switching our existing client base to such a platform, with a view to offering better service and investment performance as a result.
Existing clients investing ‘new money' will experience similar rates to those which they have in the past.
New clients will be subject to a tariff structure, whereby the overall volume of assets being brought under management will be inversely proportional to the percentage taken as a fee.
Annual Management Charges
These are also charges imposed by the product provider, and vary upon the total sum invested and the funds held within the portfolio at any one time, for example a tracker fund, which is passively managed, which tend to carry a lower charge than an actively managed fund within the same asset class. The relative merits of active vs. passive management are discussed further in the enclosed ‘How Do We Select Our Funds?'
Fund Based Charge (Ongoing)
The fees payable to Pen-Life for management of the portfolios and the associated client services equates to 1% p.a. of the total fund value. This is a flat rate applicable to all clients across all platforms and is to defray the costs of our ongoing administration, day to day service, regular reviews, and functions of the investment committee.