A Centralised Investment Process - Joined up investment thinking

The blueprint is the first to lay out a joined-up investment approach linking financial planning, risk profiling, asset allocation and fund selection.

The guide, produced by experts at Cass Business School, part of City University London, is designed to help financial advisers create "transparent" and "responsible" investment strategies for investors with all levels of risk appetite.

It also tackles shortcomings in the advisory process that leave some investors exposed to risk beyond their loss capacity as well as addressing regulatory concerns over a lack of transparency in allocating wealth to cash.

"There is a clear need for 'joined up' thinking that straddles the four parts of any advised solution: financial planning, risk profiling, portfolio construction and fund selection," said co-author of the report, Professor Andrew Clare.

"Achieving this in one seamless process is the holy grail of investment advisory. We develop one approach to solving this problem which is theoretically and empirically robust at every stage."

Cass Professor Steve Thomas, said: "Our blueprint focuses on simple, rule-driven portfolio construction principles which minimise the needs for heroic, and usually wrong, forecasting assumptions and opaque complexity.

"The benefit of our approach is that outcomes should be more consistent with a client's aims where they seek to minimise maximum losses."

Professors Clare and Thomas lay out their approach in a newly-published white paper titled, 'A centralised investment process: joined up investment thinking'.

At the financial planning and risk profiling stages, they define a method to help financial advisers better understand investors' tolerance for risk and their capacity for loss, versus their required return.

The authors call for the clear separation of risk tolerance - a client's attitude to risk - from capacity for loss - a client's ability to withstand a fall in their investment.

"Mixing the two concepts in one aggregate 'risk' score which is then assigned to a portfolio actually confuses a client's capacity to take risk with their actual need or desire to do so," said Professor Thomas.

The authors go on to draw on the latest academic research to construct a framework for asset allocation that avoids the use of "opaque algorithms confusingly presented as tools of scientific progress".

Instead, they employ a "balanced risk approach" to asset allocation that creates multi-asset class portfolios where the risks of each asset class are equal, rather than the amounts invested in each class. A key part of their framework also involves diversifying away risk by combining different assets in a portfolio.

"This ensures that the risks are not only balanced across each major asset class, but also within each asset class," explained Professor Clare.

At the fund selection stage, the authors show that it is possible to populate the portfolios they create with winning funds using the example of Clever Adviser Technology Ltd (Clever).

Clever seeks to choose the best outperforming funds for each sector. If a fund falls below a pre-set threshold, a recommendation is issued to the investor to switch into the highest risk/performance weighted fund. This monitoring process is delivered every month. It achieves this by scoring each fund in each sector against criteria such as the Sharpe ratio, alpha, average six month performance and relative volatility.

"Overall, it would seem that inserting the specific funds recommended using the Clever choices would have led to an improvement in the performance of our 'core' portfolio of 200 basis points a year with little or no increase in volatility, or crucially, maximum loss."

The full report can be downloaded at the link below.