Can Strategic Compliance Become and New Standard - Financial Simplicity

Can Strategic Compliance Become a New Standard?

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Can strategic compliance become the new standard? | May 2010 01BEST PRACTICE CLIENT SERVICE

Q. We’re starting to see a shift from “transactional” compliance to “portfolio-based compliance” in wealth management: What does this actually mean?

SH: Before considering the implications of this shift, it’s important to establish a

lexicon of sorts as misleading terminology can bury the key points. Transactional

compliance is the utility within wealth management currently employed to

implement buying and selling decisions consistent with a firm’s highly skilled,

professional investment research.

The wealth management industry uses the transactional compliance utility in two

key ways: to ensure transaction-based consistency with in-house research views and

as a quality assurance standard (for which the Approved Product or Recommended

Research Lists are the primary tools). Financial advice offered in accordance

with an APL or recommended list forms the basis of compliance and, with that, a

quantifiable risk management discipline.

However, transactional compliance does not, and cannot, consider what is in the

best portfolio-specific interests of individual clients. This is where portfolio-based

compliance becomes important.

Q. So where does portfolio compliance come in?

SH: The investments comprising a client’s portfolio could actually be entirely

compliant with a firm research’s recommendations, or with its APL, but be

disconnected from what might be in the specific client’s long-term interests.

Potentially, one could encounter a situation in which a client has a fully compliant

portfolio from a research or Approved Product viewpoint, but the mix of securities

does not actually support the client’s highly individual, long-term goals. The potential

for strategic shortfall in the composition of a client’s portfolio is an issue of portfolio

compliance.

What we’re really talking about is ‘cradle to grave’

compliance – vertically integrated at all points

of the investment management process.

A sustainable process cannot be built around

exceptions.

‘Strategic’ and ‘dynamic’ are not adjectives one automatically associates with compliance in wealth management. Given that the objective of compliance is, and must be, to ensure portfolio managers do not breach prescribed investment parameters, compliance is a limiting function. In generally being applied as a check of a transactional, or product-based, decision already made, compliance has been a tactical tool. However, transactional and product-based compliance is now being extended into a new paradigm of strategic compliance. With the advent of smart, flexible technology, compliance can be moved to the front end of the investment process and applied throughout as a client-tailored overlay. Beginning with the client’s own rules, preferences and constraints, strategic compliance is that which is vertically integrated throughout the entire investment process. In the third instalment of our discussion series, Stuart Holdsworth considers how strategic compliance aligns, in a way that has not been achieved previously, organisational needs with those of the client and the wealth adviser.


Investment professionals agree that no single security has long-term predictability.

You can really only get meaningful predictability from a broader, diversified pool.

Over time, investment security selection within a sector will not be a consistent area

of outperformance in portfolio management. Certainly, one gets exceptional stock

pickers but they are just that – exceptional. A sustainable process cannot be built

around exceptions.

To this end, an increasing portion of wealth management professionals are adopting

an asset allocation approach which mitigates the effect of security and region-

specific risks as an effective framework for portfolio construction.

Q. So asset allocation and portfolio compliance are synonymous?

SH: Almost. Returning to the importance of our lexicon for the moment, it would

be more accurate to say that asset allocation drives, or results in, a portfolio

compliance utility. It is important to note that this utility is complementary to that of

transactional compliance.

The combination of these two compliance utilities – simultaneously and

continuously applied – will result in a new level of client-centricity we have not seen

before. Client-centricity is largely risk and time profiled. With risk and time profiling,

this generally means working out an allocation of assets that achieve the correct

balance with a correspondingly greater level of certainty.

Q. What are the elements required for asset allocation and, resulting from it, a portfolio compliance utility?

SH: A vital constituent in the asset allocation process is clearly a model portfolio:

However, it is important to introduce model portfolios which are actually PRE-

compliant in both their individual security selection and asset allocation. A model

portfolio can be pre-compliant at a portfolio level in its asset allocation by being

constrained to the parameters of a client-compliant asset allocation framework. To

be specific, the client’s rules, preferences and constraints are directive in the setting

of the end portfolio.

Using pre-compliant models and client-compliant overlays, portfolio rebalancing

operations will yield an immediate and transparent compliance. This is achieved

by using a continuous client-centric overlay on top of all asset allocation model

decisions. What we’re really talking about is ‘cradle to grave’ compliance – vertically

integrated at all points of the investment management process.

You score a portfolio management Bull’s Eye

when your process starts with your client’s highly individual preferences

ahead of ANY other consideration.


Q. Compliance, vertically integrated at all points of the process – what does that look like?

SH: Given that we’re all comfortable with the idea of hitting targets in investment

management, imagine a multi-level target which includes all aspects of the

investment process within your firm’s current compliance regime. From the outer

ring, you have fundamental compliance with ASIC licensee requirements; moving

in one ring, you achieve transactional compliance through research and adherence

to your firm’s recommended list or APL. You achieve portfolio-based compliance

in the next inward ring with the use of model portfolios and broad asset allocation

guidelines used as an overlay to the client’s portfolio. However, in the innermost ring

– the Bull’s Eye – the overlay is a client-specific one.

You score a portfolio management Bull’s Eye when your process starts with setting

your client’s highly individual rules, preferences and constraints in advance of any

other consideration.

This is the emergence of strategic compliance. If the research is being applied in

the specific interests of the individual client, not only is this something to keep the

license holder or regulator happy, it will be inherently good for the client. The quicker

adjustments can be made to individual portfolios consistent with robust research,

the better it will be for the client AND the firm. Strategic compliance can provide a

demonstrable, quantifiable and measurable improvement in client service.

Q. So strategic, portfolio-based compliance requires an overlay of the client’s own individual requirements?

SH: Yes, portfolio compliance introduces a continuous application of the client’s

individual agenda over the broader investment process as an overlay. Whilst an

adviser might agree with a preset asset allocation range, this might have to be

overridden with client-specific instructions. If these instructions are applied after a

portfolio review, compliance and meeting the client’s long-term goals become time-

consuming and difficult.

As research recommendations change in volatile markets, a wealth management

practice that employs strategic compliance can take comfort that, when

checking client portfolios for compliance, the research is also being implemented

instantaneously and consistently across an entire client base. As a result, every

individual client’s needs – even though all these needs will be a little, or a lot,

different – are considered equally.

By mixing these tools in a slightly different

way with slightly more sophisticated technology,

we can produce a business redefining result with

some extraordinary implications....


Q. So, clearly, we need a system which will allow a client’s overlay to be established in advance and able to run continuously?

SH: Yes, it’s imperative to deploy technology which allows a client’s rules,

preferences and constraints to be set first: Further, it must also rebalance

automatically around the client’s pre-defined framework every time a change is

made.

To be more explicit, essentially, three functionalities are required: first, the system

must allow advisers to enter rules, preferences and constraints that clients instruct.

Second, the system must allow you to enter and adjust the asset allocations

associated with each individual client. Third, the system must allow you to input and

maintain model portfolios in all their permutations. These three capabilities need to

interact with each other not sequentially, but simultaneously in a single, continuous

process to achieve strategic compliance. Each function of the system is critical in its

own right.

However, only when they are working interdependently and simultaneously can we

achieve client-centric portfolio management which is at the centre of the target to

which I referred earlier.

Q. Strategic compliance sounds a little like alchemy.

SH: Well, to a certain degree it is. We are taking several basic processes and,

by combining them, we can produce something far greater than the sum of the

individual parts.

For example, we’re talking about fundamental tools being used right now – portfolio

modelling and compliance checking. By mixing these same tools in a slightly

different way with more sophisticated technology, we can produce a business

redefining result with some extraordinary implications. Central to the philosophy

of strategic compliance is the establishment of a clear, flexible client investment

framework. The tension and the friction that builds inside a traditional transactional

compliance model can now be overcome with a strategic approach which aligns

simultaneously the interests of the client, the wealth adviser and the business. From

a risk managed point of view, a wealth adviser can establish and maintain an asset

allocation that’s consistent with the client’s investment profile and goals. If this is

done at the outset of the client’s investment process and monitored consistently, it

reduces risk for the client, the adviser and the firm simultaneously.

Compliance should no longer be a biannual or quarterly check done ‘after the fact’ on

an investment portfolio. By accessing overall strategic compliance when the client’s

rules, preferences and constraints are being discussed as part of their overall goals,

compliance can act as a strategic guide for all suggested investments.


Q. So strategic compliance requires a step beyond model portfolio and portfolio rebalancing capability?

SH: A lot of people talk about having model portfolio capability. Model portfolio

capability is a necessary but not sufficient ingredient to achieving strategic

compliance and, by extension, client-centric service.

It’s about being able to combine the model portfolio capability with the ability to

maintain and adjust asset allocation and client specific instructions at a tactical

level. This is a very important point. It’s not about the model defining a product.

The model is just a component in the provision of a portfolio management service.

You might have multiple models for each asset allocation scenario. The relative

weightings of each asset allocation situation are determined according to the

client’s unique risk profile.

It’s not just about portfolio rebalancing and it’s not about operating within a

standard compliance framework. It’s about having them interact within a client-

centric asset allocation framework – remaining in the centre of the client’s portfolio

management target. In this way, a wealth management group using strategic

compliance can demonstrate rapid, flexible servicing of clients as well as meeting

transactional compliance obligations.

Finally, it’s important to note here that we are not simply talking about one-at- a time

tailored client overlays. We are talking about being able to apply an individualised

approach in a mass framework: Strategic compliance is also fully scalable

compliance.

Q. Can you give an example of scalable strategic compliance?

SH: If you have an allocation to Australian Equities but must, for whatever reason,

exclude a big stock in that sector, this will have significant implications for the

client’s allocation adjustments. If these adjustments are not facilitated continuously

in advance, the implication is that you are going to be scrambling with manual effort

at the end of each decision-making cycle. This is not efficient and impossible to scale

with large numbers of client portfolios.

If we are to achieve genuine best practice in client service in wealth management (eg

that which addresses the client’s individual requirements continuously), portfolio

compliance demands on-going obligation to portfolio review. With that, there is

a new level of scrutiny and, as a result, greater level of client comfort around the

portfolio.


Q. So strategic compliance allows you to achieve a number of formerly competing goals simultaneously?

SH: Compliance, client service and portfolio management are all aligned and become

the same thing. By servicing the client strategically, you understand a combination of

their asset allocation compliance and the client overlay compliance. By looking after

your clients first, you can reduce your own business risk and that of the broader

organisation. In order to be truly demonstrating that you are acting in the client’s

best interests, you have to be highly proactive in monitoring – and that means

rebalancing even within test scenarios – the client’s portfolio. The parameters of

the client’s individual investment framework may shift many times in a year, or

even in a month, either as markets change or as the client’s circumstances change.

However, strategic compliance ensures that change, and resultant rebalancing, is a

streamlined exercise.

Best practice compliance means considering the client’s rules in an ‘overlay’ process.

Best practice client service results from the deployment of a strategic compliance

standard.

Q. Somewhat paradoxically, it sounds like strategic compliance might even save time compared to traditional, transactional compliance?

SH: This is another vital point. The process of strategic compliance checks within

defined asset allocation parameters and model portfolios can be systematised

using new technologies. Therefore, it can be performed by anyone in a fraction of

the time currently required by checking spreadsheets in a transactional compliance

environment.

You can even place the onus of compliance back to those who service the clients

if desired. Advisers can execute their own compliance checking in a continuously

strategic manner. Or, the process can be managed through a centralised group as

preferred.

Deploying a strategic compliance standard saves huge amounts of time for wealth

advisers with regular transactional compliance checks. The real shift here is that

compliance goes from being a point in time (or static) check to a continuous, dynamic

part of the portfolio management process itself.

By looking after your clients first, you can

reduce your own business risk and that of the

broader organization.


Q. So won’t the infrastructure required to maintain such a compliance regime stretch existing systems to breaking point?

SH: Most existing systems with a basic modelling or compliance checking capability

will definitely be over-burdened and most likely ineffective. If you look at the

current techniques embedded in portfolio management applications, they generally

support compliance focused on point of sale, transactional compliance, or product

compliance. For example, has Y stock actually got a Buy recommendation on it

and has client X not excluded it? That’s the traditional approach to compliance in a

transaction-dominated world. This is not the basis for a scalable business model and

therefore has limitations.

Q. So what are the technology implications of achieving strategic compliance?

SH: The technology implications are significant. Enhanced systems are required for

entering and codifying the research as well as client instructions. New systems able

to apply model portfolios and client specific overlays are also necessary. Finally, new

systems are required for continuous monitoring and executing this in an automated,

seamless manner.

The technology needs not only to codify the research into manageable, deployable

“bits” but also to ensure that portfolio assets can be assigned to each asset

category. Technology capacity is also needed to monitor portfolios against changing

asset allocations and, indeed, changing client circumstances which may cut across

existing asset allocations.

The good news is that cost-effective technology to address these requirements is

available in our market now and already facilitating the sustained delivery of this

kind of compliance.

Q. Can strategic compliance genuinely mitigate business risk?

SH: True client-centric service means being strategically proactive inside your

clients’ portfolios. It means running tests on their portfolios regularly to assess

transactional and portfolio compliance balances. Traditionally, and typically due to

conflicts of interest, we had compliance and advisory almost pulling in opposite

directions with the client somewhere in the middle. If stakeholders are pulling in

different directions, that will introduce a level of risk in, and of, itself.

If a portfolio differs from its ideal, a stakeholder (whether it be client, wealth adviser

or the firm) is carrying an unnecessary degree of risk. Remaining fully cognisant of

portfolios requiring attention in the context of the client (not just a model portfolio)

is the most effective means of reducing your investment-directed business risk.

Best practice client service means being

strategically proactive inside your clients’

portfolios.


Being able to demonstrate and achieve this continuously combines a reduction in

business risk with best practice, client-centric service.

So strategic compliance checking and client tailored portfolio rebalancing theory

actually become the same thing. Client tailored rebalancing itself becomes the

measure of compliance. If I’m calculating the rebalancing of a client tailored portfolio

and there’s an adjustment to be made, then something is out of step: whether it be

client compliance (client service risk) or house compliance (business risk). If a client

tailored rebalance calculation reveals that nothing needs to be adjusted, then we

know we have acted entirely inside the client’s own parameters. No further cross-

checking is needed and the interests of all stakeholders remain aligned.

Q. So, consistent with the move towards client-centricity, compliance might address the client’s specific needs as opposed to just satisfying the regulatory needs of an organisation?

SH: Yes, that is the direction we’re headed. It’s important to note that, even from

the organisation’s point of view, that’s a desirable outcome. Also, what this means

in terms of compliance is not the nightmare one might expect. Organisations must

merely adopt a compliance regime that focuses not at the point of transaction, but

rather, begins with the client. For a wealth adviser, this is an on-going obligation

embedded in every aspect of managing the client’s portfolio – from conducting

the Needs Analysis to the first SOA and on-going review. Whilst the client’s

portfolio should not move beyond the boundaries of a firm’s APL or set of research

recommendations (eg the outer limits of the portfolio target defined earlier), it

could have infinitely more flexibility within. Strategic compliance provides us all with

a clear, quantifiable means of repeatedly scoring that Portfolio Bull’s Eye.

Just because a decision is compliant with the legally sanctioned ‘house’ view, does

this mean it is aligned with the client’s best long-term strategic interests? Are

decisions enabling the investment process to remain in the centre of the client’s

portfolio target area at all times? In the wake of the GFC, that is the question

needing an answer.

Strategic compliance provides us all with a

clear, quantifiable means of repeatedly scoring

that Portfolio Bull’s Eye.

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Can Strategic Compliance Become and New Standard - Financial Simplicity