Running the Investment Compliance “Gauntlet”

As most people know, I focus on helping RIA professionals with both compliance and risk management issues.  Far too many times I have performed compliance audits where the RIA has all of the required files and manuals, but a poor or virtually non-existent risk management program.  As a result, the RIA leaves itself exposed to unnecessary liability risk.

Over the years, I have created a risk management system that I refer to as the “Gauntlet.”  The Gauntlet is based upon various legal and regulatory decisions that outline certain minimum standards that RIAs are expected to meet in providing investment advice to the public.  While there are other standards which may or may not apply to any given situation depending on the circumstances involved, the Gauntlet’s criteria should always be met.

Criteria Number 1 – Suitability – The suitability standard applies to both RIAs and broker-dealers.  The Chase decision established a two prong test for suitability based upon both a customer’s willingness and ability to bear investment risk.  There is an increasing trend to also assess an adviser’s advice based upon a customer’s need to assume the level of risk inherent in the adviser’s advice, the “why” factor. Finally, assuming the investment advice is otherwise suitable, there is a final hurdle as to how much of an otherwise suitable investment product is suitable, the quality versus quantity issue.

Criteria Number 2 – Cost Effectiveness – As a fiduciary, an investment adviser has a legal responsibility to effectively manage a customer’s fees and expenses and avoid unnecessary costs.  The impact of  fees and other costs can dramatically reduce a customer’s end returns.  A study by the General Accounting Office estimated that each additional 1 percent of fees reduces an investor’s end returns by approximately 17 percent over a twenty year period.

In assessing the impact of fees and other investment costs, it is also important to factor in the possible impact of “closet indexing,” where the majority of an investment’s return is attributable to the performance in a market index, not to the efforts of an investment manager.  A study by Ross Miller found that the effective active expense ratio of actively managed mutual funds is often 5-7 times the fund’s stated annual expense ratio due the fund’s high R-squared rating.  R-squared is a measurement of the correlation of a mutual fund’s performance to a relative market index.

In assessing the impact of fees and expenses, I actually use a proprietary measure which factors in various issues, including an investment’s volatility and an investment’s fees.   expenses.  While advisers obviously cannot use my proprietary formula, a quick rule of thumb is that mutual funds with high R-squared numbers and high active expense ratios are rarely in a customer’s best interests.

A good securities attorney is going to explore these areas.  Consequently, a prudent investment adviser will be proactive and factor in these issues before advising a customer.

Criteria Number 3 – Effective Diversification – The final step in the Gauntlet is assessing the effectiveness of the diversification of the overall portfolio recommended by the investment adviser.  Far too often I see portfolios that appear to be diversified based upon the fact that there are various types of investments in the portfolio, the “visual” test, but the portfolios are not effectively diversified due to the high correlation of returns between the various investments.

In some cases this lack of diversification may be due to the number and/or quality of the investment options provided in the asset allocation software being used.  The fact that a software program’s output may be affected by its inherent limitations is no defense for an adviser.  It is incumbent on the adviser to recognize such shortcomings and to adjust their advice accordingly to ensure the quality of their advice.

Criteria Number 4 – Stress Testing – As an added level of protection, I always recommend that an RIA stress test their portfolio recommendations before providing them to a customer.   While the legal recognition of the value of stress testing came from an ERISA proceeding, the reasoning behind such a requirement and the value of same is equally applicable to investment advice in general.

I actually use two forms of stress testing.  The first form of stress testing involves a proprietary formula which factors in both long-term and short-term historic volatility.  The second form of stress testing involves the analysis of rolling periods of returns, typically using three and five-year time periods.  While advisers obviously cannot use our proprietary formula, calculating rolling three and five-year information can be done relatively easily.

While some advisers may see the Gauntlet as a hassle, prudent investment advisers realize the value of the Gauntlet both as a marketing tool and an effective risk management tool to boost the quality of their advice and to protect their practices against unnecessary liability exposure.

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors and investment fiduciaries on sound, proven investment strategies that will help them protect their financial security and/or avoid unnecessary fiduciary liability exposure.
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