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Investment Process – A Guide
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Contents
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Introduction
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Risk Profiling
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Asset Allocation
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Asset Selection
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Reporting
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More Information
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External Consultants
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Introduction
Assessing the level of investment risk that a client is willing and able to take - and the suitability of that investment - is core to any recommendation an Adviser makes. This document focuses on the Novia investment process and planning tools and the level of risk that a client is willing to take when making an investment.
It does not consider the ability that a client has to make an investment which will be influenced by
The extent of the financial assets and liabilities that a client may have
The client’s capacity for loss, that is, the ability for the client to absorb falls in the value of their investment and still meet their liabilities.
Any outstanding debts. Before recommending an investment the Adviser shouldconsider whether the client would be better off repaying any outstanding debt. The level of risk that clients are willing to take will generally be secondary to their ability to take that risk.
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Investment Process
Novia have used the best in cutting edge technology alongside academic rigour and investment experience, both internal and external, to create the planning tools and portfolio construction process which sits at the heart of Novia. This process ensures Advisers can effectively and efficiently match an investment portfolio to the risk and reward objectives of their clients.
Novia offers Advisers full flexibility in the investment process. Using our quick and easy online technology Advisers can simply choose individual investments from our broad range to populate a portfolio for a client and benefit from all the convenience and reporting functionality available. Alternatively, Novia enables an Adviser to complete the full investment process from start to finish through the service – risk profiling, asset allocation, asset selection and finally reporting using our integrated online tools. The full investment process available through Novia and the steps involved are outlined in the rest of this guide.
This investment process follows four standard steps which enable Advisers to create and communicate a portfolio that is optimised to meet the objectives and risk profile of a client.
1. Risk Profiling 2. Asset Allocation 3. Asset Selection 4. Reporting
Our investment portfolio process uses fully integrated tools to seamlessly construct a portfolio using these steps via the Novia platform.
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Risk Assessment
Assessing an individual’s attitude to risk forms an integral part of the suitability process undertaken by Advisers. This is based upon an Adviser’s assessment of two elements which affect an individual’s approach to investment:
1. Capacity for risk 2. Appetite for risk
An Adviser will typically look at capacity for risk as part of their overall client assessment – through gathering client information and assessing factors outside any proposed investment such as:
Other assets and sources of income
Liabilities they may face
Timing and future plansAppetite for risk can be assessed using methods such as risk profiling tools. Novia provides a risk profiling tool as part of investment process explained in this document. We provide a questionnaire that delivers an appetite for risk ‘score’ for each client – based on the answers they provide. Whilst this is an important guide it must be used as part of an Advisers overall risk assessment process and in conjunction with their exploration of a client’s capacity for risk.
Risk Scoring
Risk scoring is an integral part of the portfolio construction process. Clients are assigned a risk score from 1 to 10 following completion of an online questionnaire and scoring module or as selected by the client/Adviser themselves based on their understanding of that client’s investment profile.
The risk score is essentially a measure of an investors’ appetite for risk in their portfolio. This is then matched to the theoretical volatility (guided by independent research and reviewed regularly) of a potential portfolio and is used as a means of selecting a particular optimal long term investment strategy within the Novia investment tools.
Questions asked
The risk profile questionnaire uses three types of questions in order to determine the risk score: 1. Understand a client’s
investment objectives These questions obtain factual details about client time frames for the investment (ie time before assets will be drawn on and over what period they will be spent), amount to invest, income details etc.
2. Obtain a client’s view on investment risk
These questions aim to find out how much risk the client is willing to take on.
3. Assess a client’s
attitude to risk These questions look to find out how the client would react to good, or more importantly, bad outcomes in the investment portfolio and what mitigating actions would be available.
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To calculate the risk score, each question’s possible answer is assigned a score between 0 and 100. In very broad terms, this score indicates how far up the risk scale a client is prepared to go, based on this question alone. Each question also has an 'importance weighting', as some questions are more indicative of the clients likely attitude to risk and/or generally more accepted as a proxy for investment risk. The overall risk score for the risk profile questionnaire is the sum of the weighted scores for all the questions. This overall risk score is then mapped onto a risk scale of 1-10 in such a way that approximately 10% of possible scores are mapped to a risk score of 1 or 2, 10% are mapped to risk score of 9 or 10 and 80% are mapped to a risk score of between 3 and 8, following the normal distribution curve.
Investment risk in the Novia portfolio management tools is matched against volatility of the assets being bought as the benchmark. There are other ways to measure investment risk eg, probability of achieving certain target returns, possible losses in portfolio value over a specified time horizon, so called Value at Risk (VaR) and many others. However, under certain assumptions all these different ways to measure investment risk can be ultimately mapped onto the volatility of the portfolio of assets in a consistent way.
In order to use the risk profile score with the other Novia tools, in particular the Asset Allocation tool, the risk score of 1-10 is translated to annual return volatility.
Risk score mapping to annual return volatility
The basic mapping approach is such that a risk score of 1 would be mainly invested in Cash, a risk score of 3 will be based on an all Fixed Interest/Property portfolio and a risk score of 10 will be based on an all equity portfolio. Intermediate scores will have volatility that is distributed evenly (in broad terms) between the pivotal risk scores of 1, 3 and 10. Please see the table for a set of recent indicative figures below (for the current, up to date figures please contact your Regional Sales Manager or Client Services Executive who can provide you with the latest review).
Example, indicative figures – see latest Review Document for up to date details
Risk Score 1 2 3 4 5 6 7 8 9 10 Mid Point Volatility 1.95% 3.90% 6.00% 7.70% 9.40% 11.10% 12.80% 14.60% 16.30% 17.75% Range 2.93% up to 2.93% to 4.95% 4.95% to 6.85% 6.85% to 8.55% 8.55% to 10.25% 10.25% to 11.95% 11.95% to 13.70% 13.70% to 15.45% 15.45% to 17.03% more than 17.03% Expected Return * (Net Funds) 2.08% 3.01% 3.73% 4.25% 4.78% 5.25% 5.70% 6.18% 6.55% 6.78% Expected Return * (Gross Funds) 2.64% 3.68% 4.37% 4.85% 5.21% 5.55% 5.88% 6.24% 6.56% 6.80%
*The expected returns were reduced by the effect of taxation and expenses within the funds. They vary with the optimal asset allocations at each risk level and are likely to change at every review, unlike the mid-point volatilities which are likely to remain unchanged.
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Expected Returns – gross versus net
As shown above, in some optimised portfolios, expected returns may be higher in asset
allocations optimised for net product wrappers rather than gross. Whilst this may seem counter-intuitive, gross efficient portfolios may have lower expected returns than net ones (for a given risk level) as the optimiser produces different asset allocations for a given risk level for net and gross product wrappers. This is due to the fact that the optimisation takes place after
adjustments for tax and hence asset classes will have different attractions in net and gross wrappers. In the gross wrappers fixed interest and/or property will probably have larger proportions than in a net wrapper, where the likely proxy will be equities. As fixed interest and property have lower returns than equities, the asset allocations for net wrappers can produce higher return than for gross wrapper. If you specify an asset allocation, it will always be true that gross wrapper return will be always greater or equal to the net wrapper return.
Attitude to Risk
Risk Level Typical
proportion in risky assets* Likely range of returns Volatility range (return variability) Annual potential loss Monthly potential loss 1 less then 5% -1.25% to 6.75% up to 2.93% -£301 -£353 2 10% -4.00% to 12.00% 2.93% to 4.95% -£1,379 -£769 3 20% -7.25% to 17.50% 4.95% to 6.85% -£2,719 -£1,231 4 35% -9.75% to 22.00% 6.85% to 8.55% -£3,811 -£1,604 5 50% -12.50% to 26.50% 8.55% to 10.25% -£4,929 -£1,980 6 60% -15.00% to 31.25% 10.25% to 11.95% -£6,033 -£2,353 7 75% -17.50% to 36.00% 11.95% to 13.70% -£7,111 -£2,724 8 90% -20.25% to 41.50% 13.70% to 15.45% -£8,219 -£3,113 9 100% -22.50% to 46.75% 15.45% to 17.03% -£9,252 -£3,478 10 100% -24.50% to 51.25% more than 17.03% -£10,123 -£3,789 Definitions
Example potential annual loss 1 in 20 chance of losing this amount on £50,000 investment in a year
Example potential monthly loss 1 in 20 chance of losing this amount on £50,000 investment in a month
Risky assets Property, UK Equities and Global Equities
Typical proportion in risky assets* Excluding the minimum held in the Cash Facility
Likely range of returns The returns are 95% certain to be in this range, i.e. there is 1 in 40
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Range of returns in graphical form
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Asset Allocation
Asset allocation is the division of an investment portfolio between different asset classes. In its broadest definition asset allocation defines the relative exposure of a portfolio to asset classes, such as Cash, Equities, Fixed Interest and Property.Modern Portfolio Theory maintains that asset allocation is critical to efficient and effective investment strategy, accounting for up to 90% or even 95% of a portfolio’s return. The principle is that the investor should aim to achieve an asset allocation that will offer the optimal potential return for a given level of risk. The range of such asset allocations is expressed statistically as the efficient return.
The Novia Investment Process uses assumptions about asset class returns, volatilities and correlations that are long term in nature ie, they do not necessarily change every time there is a change in the short term outlook. In a similar vein, the volatility assumptions are only going to change if there is a significant departure from the long term norm and the correlations may be changed only as part of an annual review. These assumptions and the optimal asset allocations provided are reviewed quarterly by experienced consultants in association with Capital Economics and other sources of research. Novia’s Asset Allocator tool uses the volatility range applied to each risk score and assumptions about asset classes to give an optimal asset allocation for a client’s risk profile.
-1.7% -4.6% -7.8% -10.4% -12.9% -15.3% -17.8% -20.2% -22.6% -24.6% 6.1% 11.2% 16.7% 21.2% 26.0% 30.8% 35.8% 41.4% 46.6% 51.2% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60%
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Asset Risk/Return/Correlation assumptions
For the technically minded and as an example, the main asset class assumptions used in the Novia tools at a recent review are shown below. For the current, up to date figures please contact your Regional Sales Manager or Client Services Executive who can provide you with the latest Review Document.
Risk & Return Return % p.a. Volatility* % p.a.
Cash 2.25 2.00 UK Fixed Interest 5.00 5.75 International Fixed Interest 5.15 6.75 Property 5.75 16.00 UK Equity 8.25 20.50 International Equity 8.25 19.50
* Volatility here refers to measure of the extent of price changes over a specified time period. It is defined as the standard deviation of the continuously compounded returns and sometimes referred to as 'historical volatility'.
Correlations Cash UK Fixed Interest Fixed Interest International Property Equities UK International Equities
Cash 1.00 0.18 0.10 -0.10 0.15 0.11 UK Fixed Interest 0.18 1.00 0.54 0.20 0.50 0.40 International Fixed Interest 0.10 0.54 1.00 0.20 0.40 0.50 Property -0.10 0.20 0.20 1.00 0.29 0.09 UK Equity 0.15 0.50 0.40 0.29 1.00 0.81 International Equity 0.11 0.40 0.50 0.09 0.81 1.00
International Equity
Using the Novia tools, International Equity can be split into different regions of the world – Europe excluding UK, North America, Japan, Pacific excluding Japan and Global Emerging Markets. At an Adviser’s discretion this can be split according to GDP, market capitalisation, consensus or it can be split either equally or specific to a clients requirements.
Non-optimised assets
Novia also enables the use of alternative assets, which cannot be optimised, through the
platforms investment process. These may include Structured Products for example. This ensures that an Adviser and client’s choice is not limited to standard, daily dealt authorised funds but embraces the full breadth of investments available. Advisers can select the proportion of the portfolio to be held in non-optimised investments through the asset selection tools and these will be displayed in full for reporting purposes.
Please note the example figures here are provided by an independent consultant actuary and are reviewed quarterly. Please ask Novia for the latest, up to date figures.
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This ensures clients and Advisers have access to a breadth of investments through a platform that was previously unthinkable and ensures the convenience and efficiency of investing in this manner applies to all assets.
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Asset Selection
Once the asset allocation has been provided, Novia’s investment tools allow Advisers to populate the different asset classes from one of the broadest ranges of investments in the industry. Novia offers a full range of investment options across all the major asset classes – see attached appendix. We make available authorised funds such as unit trusts and OEICs alongside offshore and institutional funds, shares, ETFs, hedge funds and structured products and a range of cash offerings.
Investment Tools
All investments available through the platform are classified within one of the asset classes used in the asset allocations provided. Our integrated portfolio construction tools allow Advisers to select investments for each category as appropriate and therefore build a portfolio reflecting the optimal asset allocation for the client’s risk profile. For example, these tools include:
Asset Selector – quickly and easily enables Advisers to view, filter and search the universe of assets available through Novia and then select chosen assets to efficiently populate a portfolio.
Fund Charting – allowing Advisers to research assets by accessing a comprehensive range ofperformance charts and benchmarking indices.
Model Portfolio Evaluator – enables Advisers to evaluate a client’s portfolio against model portfolios created by either Adviser or Discretionary Fund Manager and check the efficiency of the constructed portfolios against the market. Offers Advisers the ability to demonstrate a portfolio’s risk against annualised return, risk against return over a range of timeframes and print/pdf any material created.Asset Selection Options
There are a number of different options available to Advisers and their clients when selecting assets to construct a portfolio. This can be either through the Adviser selecting assets for that particular client, through the use of model portfolios for a number of clients or by utilising the expertise of a Discretionary Fund Manager to outsource asset selection.
Adviser Asset SelectionUsing this route an Adviser uses the Asset Selector to build a portfolio from Novia’s range of available investments for a client. This can then reflect the client’s risk profile and asset allocation and any client specific requirements.
Model PortfoliosAdvisers can construct a range of model portfolios to reflect a number of risk profiles, for example 1 – 10. These portfolios can then be used for a number of clients depending on their individual risk profile. These model portfolios can be amended and all clients switched automatically so that their investments match their Adviser’s choice at all times, delivering significant efficiency benefits.
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Discretionary Fund ManagersNovia also enables the use of Discretionary Fund Managers and provides the technological functionality and support to ensure such third party expertise can be utilised through the platform. This allows Advisers and clients to access a Discretionary Fund Manager’s model portfolios or appoint a dedicated investment manager to manage a specific portfolio on a bespoke basis.
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Reporting
Novia offers Advisers access to a full suite of reporting resources ensuring they can offer their clients full information regarding their investments and the process leading to the construction of their portfolio. This also ensures Advisers can meet all disclosure requirements.
Client ReportA range of client reports, suited to each product wrapper, but offering Advisers the flexibility to white label and tailor to their client’s specific requirements is available. These reports can provide clients with information regarding the use of the Novia service, the investment process, details of investments selected and the costs involved.
Portfolio ScanPortfolio Scan allows an Adviser to evaluate a client’s portfolio in full and ‘look through’ the investments selected to fully understand the underlying assets and asset classes they are invested in.
Portfolio Performance ReviewPortfolio Performance Review looks at a client’s portfolio over time and, taking into account any additional investments or any withdrawals, gives a complete picture of performance over a given period. This provides a meaningful evaluation of how a portfolio has performed for a client removing the artificial impacts of movements of money into or out of the product wrapper.
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Further Information
Further information is available from your Regional Sales Manager or Client Services Executive – if you are unsure about any aspect of the Novia investment process please contact us. Contact details and more information are available at our website – www.novia-financial.co.uk
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External Consultants
Peter Ludvik, Investment and Actuarial Consultant – Former Head of Asset Allocation at Watson Wyatt
The assumptions used and optimal asset allocation review is provided by our Investment and Actuarial Consultant, Peter Ludvik.
Peter graduated from Edinburgh University with a 1st Class Honours Degree in Mathematics and then spent 3 years on postgraduate research in the University of York. He qualified as a Fellow of the Faculty of Actuaries in 1979. Before joining Watson Wyatt as a partner in February 1995 he worked for Noble Lowndes & Partners (now part of Mercer) for 15 years in the areas of pensions, computer systems and investment, and before that for Guardian Royal Exchange for 5 years. Peter took early retirement from Watson Wyatt in 2005. Since then he continues to work as a consultant to leading investment platform providers in the areas of Investment Planning Tools for individuals.
In Watson Wyatt, Peter was Head of Asset Allocation and was responsible for asset liability modelling (ALM) and strategic asset allocation advice to major UK and international clients. He has written several papers and was a regular speaker at investment conferences on ALM, benchmarking, risk budgeting, ETFs and indexation issues.
In his professional role, Peter served on the Council of the Faculty of Actuaries and was a past Chairman of the Investment Committee of the Institute and Faculty of Actuaries and the Institute and Faculty of Actuaries Steering Committee for Certificates in Derivatives. He was also a member of the FTSE Policy Group and a member of the INQUIRE Council.
Peter has always been involved in cutting edge projects, from the early pioneering work in the 1970s of using microcomputers in life office actuarial calculations to sophisticated stochastic investment modelling of assets and liabilities. His major projects included:
ALM and strategic asset allocation advice to multi-billion corporate pension funds
ALM of the Nuclear Decommissioning Fund at the privatisation of British Energy
modelling the run-off of the non-life liabilities of Names, or Underwriters, at Lloyd's of London as part of the launch of the Equitas re-insurance company in September 1996
development of bespoke stochastic ALM systems.His current projects include the development of ALM tools, using computers, for private investors and Advisers.
Capital Economics
Novia and it’s consultants use Capital Economics as their primary source of research to inform judgements around asset allocation and the assumptions used. This research is also used during the quarterly reviews.
Capital Economics is one of the leading independent macro-economic research consultancies in the world, providing research on the US, Europe, Asia and the UK, and on the property sector. Founded in 1999, they have gained an enviable reputation for original and insightful research and have built up a wide and distinguished client base. Offices in London and Toronto produce
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Over 600 institutions across the globe, ranging from some of the world’s largest banks to boutique property investors, subscribe to these publication packages. They include fund
managers, insurance companies, pension funds, investment banks, hedge funds, stockbrokers, retailers, house builders, property developers, construction companies, building societies and specialist lenders.
Roger Bootle is the Managing Director of Capital Economics andis one of the City of London’s best known economists, having worked in or around the financial markets since 1978. As well as being Managing Director of Capital Economics, he is also Economic Adviser to Deloitte a Specialist Adviser to the House of Commons Treasury Committee and an Honorary Fellow of the Institute of Actuaries. He was formerly Group Chief Economist at HSBC and, before the change of
government, he was appointed one of the Chancellor’s panel of economic forecasters, the so-called “Wise Men”. He studied Economics at Oxford, and began his career in the academic world as a lecturer in Economics at St Anne’s College, Oxford.
This document is intended to provide information for professional advisers only and is not intended for onward transmission to clients. Novia does not provide advice - advisers must seek their own compliance/legal advice before relying on the information provided in this
