The slightly provocative title reflects what we have all experienced as investment market practitioners in recent months.  The latter part of 2011 has seen a dramatic flight to safety by many investors.  The historical reasons to invest in cash (liquidity, security, uncertainty) are as prevalent today as at any other time.  However, one significant change is that “real return” has been added to this list.  This short note sets out some thoughts on the deposit account options available to the risk averse investor, the considerations required before any investment decision is made and questions whether logic is the casualty of slick marketing in certain cases.

Deposit Accounts – the silver bullet?  

Deposit accounts serve a very important purpose and most if not all mature investors operate at least one such account.  In recent years, deposit accounts have been wrapped in pension and life structures to widen their accessibility and this option has proven particularly popular. 

The extreme (self-inflicted) trauma experienced by Irish banks in the past 4 years has prompted new and aggressive interest rate pricing practices.  The understandable fear of many investors has led to many deposit options being embraced.  However, it is worth considering some of the factors that mean not all deposit accounts are the same and that, in certain instances, deposit accounts may not be the answer.  Historically, depositors had no real need to pay any regard to esoteric concepts such as financial strength ratings as most banks held strong ratings and any memories of a significant bank run were over 100 years old.  The world has changed.  Not all banks are the same any more.  Some banks have to bid a very high price (interest rate) to secure depositors’ hard earned cash and “mainstream” Irish banks now have financial strength ratings as low as BB+.  However, it is very questionable whether the depositor is being rewarded in many instances for the extra risk that they take (see later in this note) when they place their deposits with certain banks.

While deposit accounts carry a degree of security of the capital sum, there remain other risks with using deposit accounts in addition to the fundamental risk of default:

• Liquidity risk – premature access to funds may only come with payment of an interest penalty or may not be possible at all.
• Inflation risk – quantitative easing (printing of money) has yet to begin in Europe but there is a strong belief that 2012 will herald the rolling of the printing presses by the ECB.  This will inevitably create upward pressure on inflation.  Deposit accounts are an awful hedge against this risk.
• Currency risk – Will the euro exist in 12 months? If Ireland were to leave the euro, will a new Irish currency be devalued? Almost certainly, yes.  All of this spells a dire outcome for a depositor stuck in an inflexible Irish domiciled (old) euro account if Ireland were to leave the euro.

Do I get paid for the risk?  

Banks borrow from depositors at a certain rate and aim to lend out those deposits at a higher rate; the difference being their margin.  The Irish deposit environment has seen aggressive competition between banks as they compete for depositor funds. Their main weapon is the interest rate.   With any return, there is some element of risk. Identifying the risks and assessing whether or not the investor is being compensated for these risks is vital. Firstly, the risks associated with tying up money in a fixed term account are straight forward. They include inflation risk, currency risk and liquidity risk. 

The other important risk is default risk. To illustrate, a German Government bond is currently rated AAA and an equivalent Irish Government bond is rated BBB+.  Currently, the 5 year German bond will yield you 0.77%, while the Irish bond will yield 7.3%[1].  Many Irish banks are currently rated at less than the Irish Government, yet they do not offer a higher return. Therefore, the investor is not being compensated for the risk assumed. 

If you don’t know what is going to happen, diversify. If you do know what is going to happen, diversify.

“Don’t put all your eggs in one basket” – a well worn mantra but one that contains more than a grain of truth when it comes to using deposit accounts.  .  It is not unusual for investors to hold a number of deposit accounts across a number of institutions. This type of strategy can make sense as it helps to decrease the impact of default and, very importantly, provides a method to manage the inherent risks mentioned above.

Some readers may know someone that was directly affected by the failure of the Icesave deposit provider in the United Kingdom in 2008.  The Icelandic parent Landsbanki failed and all deposits were lost, at least until the UK Chancellor of the Exchequer stepped in on an ex gratia basis to cover the losses.  A dispute rages on between the United Kingdom and Iceland to recover the cost of this bailout.  Notwithstanding the eventual positive outcome, all investors and advisors that were caught up in this crisis learned a very painful lesson about the benefits of diversification.  Unsurprisingly, Icesave offered one of the highest deposit rates of interest on the “High Street” just prior to its collapse.

The real cost of fixed term rates

Fixed term deposit accounts typically offer a return that is higher than a standard demand account.  Banks can do this because they have created certainty around their liability, i.e. the investor has agreed not to come looking for their cash until the end of the agreed timeframe (if they do, they will be subject to penalties).  This uplift in rate is often referred to as the “liquidity premium”.  If a customer cannot access their investment or easily convert their investment into accessible cash, they demand a higher return for the deposit.

In the current economic environment, liquidity risk has become more significant than ever before.  The current market uncertainty has threatened a number of possible scenarios for the euro from total break-up to partial break-up to significant devaluation.  It is difficult to imagine that the euro zone can overcome its debt problems without some element of currency devaluation.  If this is the case, being positioned within a fixed term account is not the optimal location.  Accessibility and speed to effect change are critical.

This too will end….

The rates on offer in the Irish market are not sustainable due to the high costs associated with providing them. They will reduce once the banks have sufficient capital and/or the ECB begins quantitative easing ala the US Federal Reserve. In light of these risks, sensible positioning for the future is critical. 

AXA Financial

[1] Source: Bloomberg.com closing price as at 9/01/2012

The idea behind any investment is straight forward – it should grow. While the idea might be straight forward, the implementation and outcome is not. Choosing an investment strategy is difficult – there are many issues to consider and a wealth of products that claim to help.

The Consensus Concept

The Consensus approach is one of the many strategies that are designed to help investors achieve their financial goals.

The objective is to produce a return in line with the average fund manager performance over three years. This is designed to eliminate the risks of poor fund manager selection and poor asset or individual equity allocation.

In a seven horse race, the consensus runner should finish 4th – always! It will never win the race, but equally, it should never finish last – thus reducing an element of relative performance risk.

The strategy achieves this result by mirroring the average asset and country allocation of all the investment managers included in a “league table”.  A typical consensus fund will work off the average asset allocation for the funds in the relevant managed fund sector to arrive at its asset mix. Once it does this, it will then take a “passive” management approach to selecting stocks. Going back to the racing analogy, it consistently finishes in midfield .

Does the Consensus approach have merit?

If the field of horses are very fast and consistently fast, then yes there is merit in having a degree of exposure. However, that is not the case inIreland. The intention may be good, but the execution and outcome is disappointing.

There are two issues here 1. Adopting the collective wisdom, and 2. Using a Passive approach

Collective Wisdom

The sorry performance experience of the past decade confirms that the managed fund is dead. So why rely on it for your investment strategy? The old “one size fits all” approach is outdated and contradicts the two basic investment fundamentals of appropriate risk assessment and asset allocation. The typical Irish managed fund has a local fund management arm that decides on asset allocation and is tasked with managing all the components in an active manner. It is not realistic to expect that a local fund management team can emulate the research, expertise and resources in every asset class of the cream of the international fund management community. Pooling these local fund managers into a collective mix does not improve your odds of outperformance.

Consensus funds argue that asset allocation risk is removed because they use the collective wisdom of all the managed funds in their sector to determine asset allocation. To quote one leading provider: “There is no asset allocation risk within the Consensus Fund as it mirrors the collective wisdom in the industry”.  This is flawed logic. Firstly, asset allocation risk can never be removed, it can only be managed. Secondly, and more importantly, by using the average of the available managed funds, the consensus fund is relying on the collective wisdom of the other fund managers. One must bear in mind that the historical asset allocation of these funds is strong evidence that these managers closely watch each other and compare their performance against each other. As a consequence, the performance difference between each manager is minimal.

Passive Approach

The debate between active and passive managers has been raging for years. Both sides have merits and it is not necessarily an either/or option. Many of the most successful investment portfolios blend elements of both approaches to arrive at a portfolio that suits the client’s needs in terms of risk/reward and, of course, cost.

The issue here is not so much the passive approach, but rather the cost of this passive approach. Many consensus funds come with a 1% annual management charge. The consensus fund is a passive fund in disguise. A good quality passive fund from an international/global provider with the required scale can be accessed for 0.5% – half the cost of the average Consensus fund. Therefore, before you start, the cost is twice the industry average for passive funds. To highlight the importance of this point, that difference in cost alone will save the investor €2,717* on a €100,000 investment over a 5 year period! (*Assumes 6% growth and a 0.5% annual charge)

What can you do?

Go back to basics:

• Manage your risk and pick the best funds.
• Diversify – do not rely on one local life company.
• Use funds that benchmark themselves against international competition, not local.

Take the table below as an example. It compares the Irish Balanced Managed Sector average, the Irish Life Consensus Fund and the AXA Financial Model Portfolio 3 (suitable for the Balanced Investor[1]). The power of real diversification and access to the strongest international fund managers is self evident. There is a 21% out-performance over a 5 year period.

Questions you should ask your financial adviser?

1. Are Consensus funds right for the current market?

Global markets have undergone a roller coaster ride in response to the Euro crisis and fears over slow global growth. Are consensus funds the appropriate vehicle to cope with market volatility? Active managers can place investors in winning stocks or attractive bonds, but in a stall speed economy where market returns are suffering big weekly swings, positive market returns can take longer to materialize. Blending both passive and active gives the investor the best of both worlds.

2. Can you respond to changing market conditions?

When you buy a consensus fund you effectively give up control and flexibility. You are no longer able to increase or reduce exposure to an asset class as you see fit. 

3. What am I paying a manager for?

The deal with investing in an investment fund is simple. You loan your money to a fund manager or to a group of fund managers and you pay them a fee to grow your money in a predefined manner. If they have an active approach, you pay a little more but you are entitled to expect better than market performance over the long run. If they have a passive approach, you pay a little less but expect a performance broadly matching the market. With a consensus fund, you pay a higher price but don’t get the enhanced performance. A good deal for the company but not good for the investor.

4. What can I do about it?

Get advice from an independent financial adviser.

Go back to basics, assess your attitude to risk, build an asset allocation to match and then select international investment funds to populate that asset allocation. Ensure that these funds have been selected using a robust and truly independent investment fund selection process. 

Diversifying your investment across a number of asset classes and top performing funds to match your investment and risk objective is good advice. For the reasons above, a consensus fund is unlikely to be the way to achieve this.

Alan McCarthy, Senior Investment Associate
AXA Financial: 01 471 1317 or Alan.McCarthy@axa.ie

A work colleague and I have just completed the Graduate Diploma in Financial Planning. This is one of the necessary steps towards completing the relatively new industry qualification – the Certified Financial Planner or CFP.  As many will be aware of the course and its objectives and may be considering enrolling, I thought it would be useful to share my perspectives having just completed the final two modules.

However, rather than discuss the course in a diarised micro manner, I think it is more relevant, and possibly more important to discuss why this qualification is relevant at the macro level and how it might help change and shape the industry’s future.

Suffice to say that each module was interesting and valuable – while there were certain modules where I expected not to learn much, I found that I learned something from all modules. Interestingly, speaking to other members of my class, this seemed to be the popular view. It is not until you sit down and prepare for the final exam that you realise how much you have covered – no matter how much experience you have in the subject area.

One key learning for me was the interaction with other members – specifically listening to their opinions and approaches. There was a diverse mix of individuals on my course, all of which brought something to the table. This adds to your personal learning and also to the atmosphere of group projects and class discussions.

The concept behind the Certified Financial Planner (CFP) course is clear – to raise the standard of personal financial planning advice provided to clients by our industry. If this is achieved, there are many benefits to be gained by the industry; increased respect from clients, greater integration across other professions, improved sustainability and higher revenue potential for the financial planning professional. The industry is not the only beneficiary – and one would argue, not even the primary beneficiary – the end client will also gain from a more integrated, deeper and holistic planning service to aid them in achieving their goals.

All good ideas are simple – it is the implementation that creates the real challenge.

We are all aware that our industry has suffered over the last 3 years largely due to the macro economic conditions that currently prevail. This problem has been compounded by clients decreasing level of trust in financial services and the real financial losses that many suffered. The human reaction, during and after a crisis, is to look for somewhere to apportion blame. We all have a tendency to polarise discussions and turn the outcome into a “black or white”, “yes or no” scenario. Rightly or wrongly, our industry is under this spotlight.

The industry is not blameless either.  With hindsight, product selling overtook financial planning as the main income stream and priority with areas such as risk and diversification not getting the due attention that they deserved.  The consequence of this practice is well documented.

Our industry needs to evolve and improve – the competition for scarce resources is ever growing. This, I would argue is a positive and necessary development. It raises the bar for everyone. This is what the CFP course delivers on.

I decided to complete the Graduate Diploma in Financial Planning (CFP) course for this very reason.  18 months later, the lectures are finished and the final exams completed. The last stop is the official CFP exam in February 2012.

To get to this position, 6 modules covering various aspects of financial planning were completed. When I look back on the experience the obvious questions spring to mind;

• Was it worth it?
• What have I gained from the experience?
• Does this type of qualification help the industry (and me)?

My situation may be slightly different to the average CFP student profile. I work in the investment area, but rather than give direct financial planning advice to retail clients, I work alongside financial advisers hopefully adding value by guiding them towards good international investment funds and aiding portfolio construction. I see an alignment of interest here between the investor, the adviser and my company.

This is a key part of the CFP – alignment of interests. The CFP helps to change the dynamic in which one views the industry. Financial advisers are to a degree, reliant on the product providers for revenue. Many need to sell a product to generate revenue. Therefore, the commission rates that the product provider offers will determine the revenue generated and therefore reduce an element of the control that the adviser has over their own bottom line.

The CFP focuses on placing this control in the adviser’s hands.  While revenue can still be generated via traditional commissions, it opens up a world of delivering value to a client in a manner that can justify payment regardless of the method. The client becomes the centre of the adviser’s focus with their interests being aligned with the adviser.

The Grad Diploma in Financial Planning is completed over 6 modules;

1. Principles & Ethics in Financial Planning.
2. Asset Management.
3. Retirement.
4. Tax & Estate Planning.
5. Financial & Risk Management.
6. Integrated Financial Planning.

Each of these modules aims to educate and enhance the students’ knowledge of the subject from a technical and financial planning aspect. This is where the value can really be seen in completing the course.

Financial plans or strategies can be complicated by their very nature. They seek to match financial goals and objectives with often limited or scarce resources. Financial plans are not a panacea. In fact, very often, they will lay bare the harsh reality of a financial situation, or highlight the sacrifice that must be made for a financial plan to come to fruition.

We all strive to best match and respect our client’s goals. However, given the nature of our role, there may be recommendations, options or suggestions that clients were not anticipating or do not favour.

Financial plans do not necessarily need to mention or promote products. If products are needed or required, they can be discussed at the appropriate time. Deciding and advising how best to achieve the clients’ stated goals is the priority of CFPs at all times.

Our industry suffers from complexity and reliance on product selling. Independent financial advice is the classic bundled service. Advice is bundled up with product and product is bundled up with remuneration.  This is the standard model.  While the CFP does not suggest it should necessarily change,  it does challenge the student to question and seeks to clarify and improve the model.

How many times has work been carried out for a “prospective” client only to see this work not bear any fruit? Whether we like it or not, in this situation, clients who engage pay for the clients who don’t.  This is not sustainable.

You might ask yourself, what this has got to do with the CFP.  In my opinion, this is the most valuable aspect of the CFP. It has helped to create focus on the bigger and longer term picture rather than short term benefits. It helps to create focus on the value that the client is receiving. It helps to align interests of all parties. It moves the adviser away from being a product seller to a financial planner. This is a necessary step to move the industry towards the future.

Planning is the long-term process of wisely managing a client’s finances so they can achieve their goals, while at the same time negotiating the financial barriers that inevitably arise in every stage of life.  The CFP delivers on this.

Going back to those questions earlier on;

Was it worth it for me? Yes -There were frustrations and challenges along the way. This is part of taking any qualification. Everyone’s experience will be different to a degree. It depends on personal circumstances (I have a day job, a wife and two small boys so attending two lectures a week, group work, assignments, study, etc. was challenging). The specific learning’s will also differ (I work in the investment area, am a QFA and have Masters in Economics).

What have I gained from the experience? – Although there were topics covered that I have a good knowledge in, I still took something new from these topics. Of course, there were new topics and concepts that I had not been exposed to. This will be different for everyone taking the course. Interaction and debates during the classes were both educational and entertaining.  Thankfully, these debates were facilitated by all the lecturers as it is often the best way to understand new concepts.

Does this type of qualification help the industry? – That remains to be seen but the industry is changing.  One only needs to look across the water to see the future of how financial advice may be regulated inIreland. The only debate is when, not if. Competition is tougher, margins are tighter, surviving and prospering in the changing financial planning world takes hard work and innovation. While the CFP does not provide you with a silver bullet, it provides a strong foundation towards raising the standard of financial planning advice available to clients.

I started this piece with a quote. It seems only right to finish with a quote from a well-known orator and student of life;

“Every time I learn something new, it pushes some old stuff out of my brain”
– Homer Simpson.

Maybe it is time for our industry to push some old ideas out and bring in some new ones.

Alan McCarthy, Senior Investment Associate

AXA Financial

 These series of words are capable of sending a shiver down the spine of any financial adviser. An ambiguous process for dealing with risk profiling and investment planning can make advisers vulnerable to claims by unhappy clients. This article is aimed at offering you, the adviser, some guidance in how best to position your investment advice.

The terms “low” and “high” risk seem reasonably clear and unambiguous, but in investment terms are not quite so. We all should be risk averse, meaning that, if the prospective returns are equal, we prefer safer investments to the more risky. Many investors however desire high returns while taking low (or even no) risk but this is incongruent with the way financial markets actually work.

To invest successfully we must embrace risk. Financial security is not achieved through avoidance of all risk; this is impossible. It is achieved through appropriate diversification. What that ‘appropriate’ level of diversification is, will depend on individual client circumstances. A proper assessment of a clients risk tolerance is the first step to any meaningful discussion about asset allocation and diversification. This provides a platform for robust investment planning. Without it, there is too much room for ambiguity, which is dangerous.

The foundation of an appropriate investment strategy comes from knowing who your clients are and what your client wants. An effective method of engaging and building their trust is by a thorough understanding of their unique financial risk tolerances.

So how do you go about assessing the risk profile of a client?

First, a word on risk itself. Investment convention dictates that risk is the volatility of returns, i.e. how variable the returns are from month to month or year to year. The more volatile an asset the more in terms of a return we require to invest in it. Whatever your views about the efficacy of this approach to assessing a clients risk profile, there is no accepted alternative.

Assessment of a clients risk profile has heretofore been done very unscientifically. It usually has involved a discussion of prior history of investing and a casual observation of investment goals. Risk profile was assessed under a scale of one to five (one being conservative) with a firm anchor around a score of three. With the regulatory environment such as it is and the compliance hurdle rising, this largely subjective assessment of risk profile will not pass muster going forward.

A more sophisticated, though by no means complete, solution has been seen through the introduction of risk profiling software. From the perspective of objectivity and consistency these tools tick the box. They are there to aid, not necessarily direct or enforce the investment decision making process. It supports the planning process by giving a consistent methodology. It should also provide reassurance and a level of protection to advisers.

A client’s risk profile is comprised of two aspects: the client’s risk attitude and their risk capacity. Risk attitude is psychological. It is the measure of a client’s personal comfort with risk — where does the person strike the emotional balance between seeking a favorable outcome versus risking an unfavorable outcome? Risk capacity, measures the ability to sustain a less favorable outcome without impacting the original goals and objectives.

Many risk profiling systems attempt to measure the latter, without taking account of the former. We have all witnessed cases where a client’s attitude to risk changes with circumstances. A robust risk profiling system will use a psychometric system for dealing with a client’s attitude to risk, which are malleable. No system however detailed will ever capture and account for the range of emotional biases we all suffer from when investing money. At the very least, risk profiling must acknowledge the distinction between risk attitude and capacity.

Managing risk requires understanding and skill, but it is not as difficult as industry insiders might have you believe. With the appropriate tools, investment planners can identify the keys risks an investor faces, and provide the platform for an open discussion of those risks and the reason for embracing rather than avoiding them. The client is in a much better position to endorse and commit to the riskiness of the recommended portfolio.

No standard risk selection process can offer the perfect solution. Not all clients slot neatly into pre-defined “one-size-fits-all” categories. Nothing can replace getting to know a client individually. However, investment planning tools add much needed consistency and credibility to the assessment of risk and the pursuit of return.

AXA Financial

Take an example: The best-performing fund in the European equity sector over the five-year period to31 March 2011achieved a cumulative return of +12%. The worst performer achieved a return of -20%. This emphasises the greater importance of selecting the right fund rather than the lowest annual management charge.

Illusory Benefits

Similarly, investments are often sold on the basis that they offer an extra allocation rate of, say, 3%. This seems like a great deal for the investor: invest €100,000 and the benevolent life assurance company will grant you an additional €3,000. However, to focus solely on the extra allocation rate is again mistaking price for value. Taking the European equity example above, an extra allocation of 3% is no consolation for being invested in a fund that delivers 32% less than the best in its class. 

Selecting a fund that offers the prospect of consistent performance is more important than the illusory benefits of management charge savings or extra allocation.AXAFinancial provides investors with an independent guide to the most consistently performing funds drawn from a global universe of 30,000 funds. The funds are selected solely on their ability to deliver consistent performance. In the long run, this is more important than allocation rates or annual management charges.

AXA Financial

Life companies have lavished many apparently attractive offers on investment advisers in recent months.  The extra allocation available can seem like free money but this would be an expensive misunderstanding of what is actually happening.  To illustrate, consider some figures.

Let’s take a typical actively managed fund with an annual management charge (AMC) of 1% p.a. before trail, i.e. 100 bps.  In simple terms, the Life Co must use the 100bps to pay for all back office expenses and to pay for any extra allocation offered at policy inception and, of course, to pay for investment management.

First, we take the cost of extra allocation.  How much AMC does an extra allocation of, say 4%, equate to?  If we assume that a policy remains on the books for 10 years, we can determine using discounted cash flows that the AMC that a Life Co must apply to cover the cost of an extra allocation rate of 4% is 60bps[1].  For comparison, an extra allocation of 3% costs 43bps.  If we use a 3% rate of extra allocation in our example, then our 100bps is now reduced to 57bps (100-43). 

Next we look at back office expenses.  A recent study of FSA returns in the UK highlighted that the average cost of maintaining policies for LifeCos is 39 bps.  It is not unreasonable to assume that the average cost in Ireland is similar.  That reduces the residual 57bps to 18bps.

18bps is all the LifeCo has left over to pay for investment management.  Is it realistic to expect adequate performance from a fund on which the manager is investing only 18bps in stock analysis, economic analysis, investment process and execution?

The pie charts below illustrate how the 100bps “cake” is allocated using 3% and 4% extra allocation as examples.

Two old adages come to mind;

“You get what you pay for” and “Pay peanuts, get monkeys”. 

Neither offers any comfort to investors.

AXA Financial

[1] Assume 10 year policy, 5,4,3,2,1 surrender penalty regime, 12% discount rate

Investment Policy Statements have been used in the pensions market for a long time. An IPS codifies broad guidelines for the investment portfolio along with clear restrictions. To use the cliché, an IPS is the road map essentially in terms of the investment journey.

An IPS places clear limits on the allocation to different assets, documenting of investment goals and clarifying the source and time of the information. This is an important aspect, as people’s memories about investment decisions become distorted with the unfolding of new information (see next section).

Why should you use an IPS?

Our memories are shaped to a great extent by the present and we frame the past using this knowledge. The results of this when we apply it to our experiences of investing in markets is fascinating. A fascinating report by Wellershoff & Partners Ltd, highlights flaws of memory which impair our ability to learn from the past and contribute to poor financial decisions.

Bad memories tend to be blocked by good ones. For those of you partial to a bet on horses, do you find it easier to remember the names of the horses you have won money on, or those that didn’t come in? If you are like the vast majority, the chances are, you can remember your winners, but not those of the losers which probably number a lot more.

In much the same way, we block the memories of some poor financial decisions with other more pleasant memories. While it is unlikely many of us will forget the disastrous equity experience in Irish financials for some time, we are still conditioned to gloss over with the more favourable decisions we have made. This conditions us to be overconfident in our abilities by blocking adverse information about our financial expertise with positive information.

A carefully designed IPS can be a versatile tool in the investment process. It functions on several levels, not least of which is as a document that protects you (the adviser) in the event of a complaint. Importantly, it is a tool to help both you and your client understand the advice that is been given and why.

How do you construct an IPS?

Each client will have unique investment considerations, but this should be covered by a standardised process to develop your recommendations.

You should design a basic template for your IPS that you can customise for each new client based upon their needs.
Firstly, most clients will never have heard of an Investment Policy Statement, so you must give a brief explanation of why you created it in the first place.

This is your opportunity to highlight that they are not being sold a product. You are a professional who uses a disciplined, effective process to design an appropriate strategy just for them.

First, you must have clear personal sense of your own investment philosophy. What is important to you as an investment adviser and what do you believe are appropriate rules to follow when investing? What is your philosophy with respect to risk, diversification, timing, buy and hold, costs/ fees, etc. These must be clearly set out before an appropriate plan can be put in place.

There are a number of steps involved in the crafting of an IPS. I have tried to break them down as much as possible here. I have provided a sample IPS separately and while, not as comprehensive as the finished article should be, it will provide a guide. It may be best to start with a blank sheet and develop it over time. You will never settle on your first attempt.

Step 1
Decide on goals, objectives and strategies.

The individual’s specific investment-performance goals should be established with appropriate benchmarks identified to monitor results.

• What is the target rate of return?
• How long is this money going to be invested?
• How much income needs to be driven from the portfolio?
• When to commence income drawdown?

These questions should be answered before an action plan is established.

Step 2
Decide on strategy for managing risk

Maximising return without regard for volatility and risk is a major contributor to the failure of most individual investors.
All investors want the most return for the least amount of risk – how one manages the risk will determine success.
Determine what the client’s tolerance and attitude to risk is. There may be a conflict with a client’s preference (i.e. attitude to taking risk) and their capacity for bearing it. This needs to be teased out with the client first by getting them to fill out a risk profiling questionnaire and then having a broader discussion around risk and return. Risk is not a single number. It is a complex concept and can only be properly addressed through informed dialogue with a client.

Step 3
Set guidelines for asset classes

The IPS should provide guidelines for the asset classes to be considered. The more specific you are within each class, the better. The allocation must take into account the need for cash flow, growth and safety. It’s best if you have 4 or 5 model portfolios which you consistently use.

Step 4
Monitor and rebalance schedule

The most important step. Retail investor success is not based on choosing the “best” investment but rather on decisions regarding timing and diversification. Investors’ have a long track record in obsessing over fund performance (usually short term) and joining the performance derby of selling the losers, very often moments before they work, in order to chase ‘successful’ Managers just as they are about to run their course.

The ability to harvest gains as investments are going up, and at the same time invest in asset classes as they are out of favour is the greatest help that the IPS can offer. The very act of writing one, will help your clients avoid the tendency for irrational decisions.

Investors need to have a written plan for how often they are going to monitor performance and when they are going to rebalance. This is the discipline that most retail investors lack. This is easily executed on a platform, but may be difficult/ expensive to implement where the policy is spread over more than one provider. Apply a sense test.

Summary on Investment Policy Statements

Earlier we referred to some flaws with our memory. Another well documented flaw in our memory processes gives rise to what is termed hindsight bias. This is the tendency to look back and see events as more predictable than they in fact were before they took place.

Take the recent credit crisis, which can be traced back to a property bubble in the US. It’s difficult to disentangle ourselves from the position that it was obvious when viewing the incident through the lens of knowing all we do now. To some it was so obvious, it’s almost as if uncertainty and chance didn’t exist three years ago.

I’m sure you have come up against this scenario several times – investors being ‘wise’ after the fact. It promotes overconfidence in investors, by fostering the illusion that the world is a far more predictable place than it is in reality.

The IPS is invaluable in terms of a documentation of events at a point in time. It functions as a very comprehensive ‘reasons-why’, but it is a sales aid, not a compliance exercise completed after the fact. When the going gets tough, an IPS is a very helpful reminder of the long term goal.

Gary Connolly
Principal, icubed

Investing is emotionally challenging. This impediment to investment success is greater than any other. The temptation to abandon well thought-out but disappointing strategies moments before they work, in order to chase successful strategies just as they are about to run their course, can be overwhelming.

Help your clients to avoid this peril by crafting an IPS.

Gary Connolly
Principle, icubed

“October: This is one of the peculiarly dangerous months to speculate in stocks… The others are July, January, September, April, November, May, March, June, December, August and February.”

This pension season more than ever will be over-shadowed by market events.  The recent turbulence has placed doubts in the minds of many investors.  The number of conservative investors has grown.  This note seeks to highlight the options available fromAXAFinancial for the more conservative investor and their financial advisor.

AXA Financial Money Market Funds

We offer Money Market funds denominated in euro, sterling and dollar. Each of the three funds is invested in short term deposits to optimise liquidity and deposit providers are selected with a view to financial security.

Model Portfolio 2

TheAXAFinancial Model Portfolio 2 was established for investors rated at the lower end of the risk spectrum by theAXAFinancial risk questionnaire. Investors with this risk profile tend to fit the following description – “The Cautious Investor looking for an investment where the return should be slightly better than that available from a high street deposit account and accept that the value of the investment could fall as well as rise. They would feel uncomfortable however if their investments were to rise and fall in value very rapidly.”

Cumulative performance and volatility to September 28th 2011

Drip-feeding

Drip-feeding is very well established as a mechanism for managing risk. TheAXAFinancial drip feeding facility is one of the most flexible in the market place with drip-feeding possible monthly, quarterly, half yearly and yearly for periods up to 10 years.

Absolute Return

AXAFinancial has the most extensive range of absolute return funds on a single platform in the Irish marketplace with the Standard Life GARS, Threadneedle Target Return and JP Morgan Capital Preservation funds.