In order to understand products we must first of all understand some basic rules. Furthermore, in order to understand why products are sold we need to understand some basic problems.
Rule number 1 – the elements, the building blocks
All investment return and all investment risk comes from the return on and the risk arising from capital invested in the economy. The return on capital as far as the investor is concerned is broken down into 3 components
Rule number 2 – the uniqueness rule
We know that the risk and the return on each of the above varies and, varies over time. How much you need of every asset depends on your financial needs, your risk preferences and the current risks of investment (stock market and economic risk).
In truth, because everybody is different, everyone should have a unique combination of these investments and because everybody’s needs change over time, this combination will change and will need to be managed.
Rule number 3 – The no free lunch rule
If you want the return on equities, you have to take the risk of equities. If you want to invest in equities while avoiding the risk of equities you will need to pay someone for taking the risk for you. Invariably this will rob you of the extra return on equities and at best, over the longer term, leave you no better off than if you had invested in low risk assets.
Rule number 4 – the marginal return rule
Transaction and management costs act as a drag on the return of each asset class, increasing the risk of investment and, in certain circumstances, possibly invalidating the rationale for long term investment in anything other than low risk/low cost cash.
Rule number 5 – the distribution rule
The ability to personalise the structure of assets, the planning of assets and the management of assets takes a certain amount of resources, asset management expertise, systems and the necessary business and services processes to do the job properly.
Rule number 6 – the allocation rule
For those who do not possess the requisite systems, the business or the service processes, the resources or the expertise to manage a specific component (US smaller companies, Canadian large caps, Asian stocks, government or corporate fixed interest etc) or the whole (the portfolio) you will use a product to access that component or to deliver a wealth management solution.
Rule number 7 – the efficiency rule
There are good products and there are bad products, there are products that solve problems and products that cause problems and a good advisor will know when and when not to use them. A product should always represent a more efficient way of gaining access to an asset class or a cheaper and more efficient way of gaining access to wealth management expertise.
Rule number 8 – the integration rule
A product should always be capable of being integrated within a portfolio without upsetting the management of risk and return or the management of liabilities or financial needs. Because of this the use of products requires portfolio construction, planning and management expertise, to some degree.
Rule number 9 – the accountability rule
All product recommendations must be justified against a lower cost and more direct method of accessing the investment.
Problem number 1
Investors are understandably and largely ignorant of the basics of investment and, in their ignorance are swayed by many a product claim.
Most individuals are therefore ignorant of rules 1, 2, 3 and 4. Even those who are normally wary of offers of something for nothing will accept a pitch from what they consider to be a registered and regulated professional.
Problem number 2
There is insufficient expertise and resources for each individual advisor to personally manage each individual’s portfolio. This means that there is not enough resources to allow every individual’s portfolio to be built bottom up from the basic investment elements (rule 1).
Indeed, an individual with a global portfolio is going to have to access a managed investment vehicle for some of that exposure, unless they are extremely wealthy and have access to asset managers that are able to research, select and manage direct equities in all markets and all market components.
Further information on this topic can be found in the valuation, allocation and management technical document, in the news and technical section of the website.
Problem number 3
The industry is resistant to integrating the management of assets with the management of financial needs for a number of reasons. Further information is provided in the portfolio problem section of the website.
Such integration would allow very high levels of personalisation (satisfying rule 2) and automation (satisfying rule 5) of the portfolio construction process. All portfolios would be built from the basic elements (satisfying rule 1), all portfolios would be unique (satisfying rule 2), reducing costs (satisfying rule 4) and allowing more flexible, lower cost wealth management solutions (satisfying rules 6 and 7).
Problem number 4
If investors are ignorant of the realities and basic elements of investment, if advisors do not possess the expertise, or the systems, or the resources, or the knowledge to personalise portfolio structure to financial needs and risk preferences, you have an impasse.
This impasse is the product.