Developing client-centric advice models has been a hot topic for many financial planning firms in recent years, with the duty of acting in the client’s best interest further cemented by the newly established Financial Adviser Standards and Ethics Authority's Code of Ethics. This has led some advisors to question whether the conventional weighting of a portfolio across today’s increasingly volatile and highly correlated asset classes satisfies this duty of care.
Ordinarily, advisors use a client’s attitude to risk to determine how to weight their portfolio for maximum returns; a method known as strategic asset allocation. Clients with a high-risk tolerance have a greater allocation towards aggressive assets – equities and property – while volatility is minimised for those who prefer capital stability by increased portfolio weights towards defensive assets – fixed interest and cash. Portfolios are rebalanced back to the original asset weights after large market movements to ensure they remain aligned with the client’s risk profile.
The rigid nature of strategic asset allocation saw investors with a high weighting towards equities sitting through the 2007-2008 global financial crisis and again through the recent COVID-19 pandemic-led falls in the belief that markets are efficient and will eventually return to historical norms; however, this cannot be guaranteed and, as demonstrated over the past decade, may not occur within a client’s investment time horizon.
The global financial crisis saw Australian equity values more than halve in 2008, only recovering to previous levels a decade later, while the pandemic caused stocks to plunge by nearly 40% from the start of 2020, to be still down by almost 20% in the middle of the year. Meanwhile, clients with a high weighting towards fixed-interest and cash are struggling to beat inflation amid record-low central bank rates.
It can be argued that the intrinsic lack of capital protection offered by strategic asset allocation is not in the client’s best interest. This is made worse by the fact that the method is focused on maximising returns based on a client’s risk profile, rather than their actual financial goals. This conflicts with the requirement for investments to be appropriate for a client’s individual circumstances under the code of ethics, again exposing the advisor to heightened business risk.
An alternative approach that addresses these concerns is offered by goals based investing. This method adopts flexible weights that allow capital to be invested in accordance with changing market conditions to limit volatility and capitalise on opportunities. Rather than attempting to maximise returns for a given level of risk, goals based investing aims to achieve a target return that meets the client’s personal financial goal within a specified timeframe.
To do this, the approach looks beyond the typical asset classes to offer genuine diversification by employing a multi-strategy approach to build a portfolio of low-correlation assets. This includes allocating capital to assets such as precious metals and currencies, as well as utilising various strategies, such as short selling and managed futures. Asset weights are not pre-determined, but move in response to market conditions.
Adopting flexible weights across uncorrelated assets and strategies to achieve client-directed objectives appears to be more in line with current regulatory requirements and is more likely to enhance client outcomes. This, in turn, reduces a financial advisory firm’s exposure to business risk.
Contact Dynamic Asset today to find out how to implement goals based investing in your business.
