Eliminate Investment Uncertainty
One of the great dilemmas we face as investment advisors is how to find the right combination of active managers and passive indices to help our clients achieve their financial goals.
This challenge has to be balanced with providing protective measures against lawsuits as experienced by Trader Joes, Ardent Health, and M&T Bank.
No one in the financial services industry has yet offered a well reasoned yet rigorous solution to solve this dilemma of proactively managing investment uncertainty.
Financial firms are leveraging ERO to solve this challenge for their investors.
Plan sponsors are leveraging ERO as a proactive measure against ERISA and retirement plan lawsuits.
The solution developed integrates the ERO portfolio construction technology with a firm’s existing strategic asset allocation process to increase the probability of better performance, manage volatility, mitigate risk and decrease liability issues.
ERO has four basic principles that establish the foundational basis for how we approach these rising challenges.
The goal is not to beat arbitrary market indices, but to meet or exceed the investor’s Essential Returns Objective (ERO) as illustrated below.
If an investor’s ERO is not achieved the investment strategy failed.
Outperforming the market is irrelevant to the ultimate goal of today’s investors.
Market volatility is secondary and more of an issue to the investor on the downside.
The rationale of this second principle is illustrated below as ERO is built on meaningful risk volatility measurements.
The primary risk is not achieving the investor’s ERO.
Most active managers’ portfolios are an assortment of management styles.
This is somewhat intuitive because for active management to achieve excess return, commonly referenced as “alpha”, the active manager’s portfolio must be structured differently than the style benchmark mandate.
Few active managers are pure to their categorized manager style.
As evidenced by William Sharpe’s Nobel Prize winning work none of the portfolios funds are style pure.
This is common for all actively managed mutual funds and separately managed accounts.
This is further compounded by the fact that current asset allocation optimizers ignore active managers’ style blend.
Said another way, every manager is assumed to be pure in their respective style category.
As a result, most asset allocation strategies are immediately corrupted upon implementation.
When the ERO methodology is overlaid in the portfolio construction process this deficiency is better addressed.
Additionally, there are compounded asset allocation implications to be considered as a result of ignoring this active manager style purity issue.
Imagine this one manager’s style analysis multiplied by the number of active managers you currently have in your aggregated diversified portfolio.
What is your actual asset allocation and how does it compare to the recommended asset allocation you think you have?
Asset allocation is critically important for attempting to achieve the investor’s Essential Returns Objective (ERO) and developing an effective and efficient portfolio structure.
Since asset allocation strategies revolve around both asset and style mix policies, it is extremely important to recognize that active managers (and perhaps some passive solutions as well) are not pure within their respective style category.
If this fact is not acknowledged, the intended asset allocation strategy will be corrupted and not actually implemented.
The investor’s ERO is more essential and uniquely different than some market benchmark’s volatility or “age-based” life cycle fund solutions.
Falling below the ERO is the primary risk, market volatility is a secondary risk considered more for investor behavioral and emotional factors.
Yet asset allocation recommendations are frequently based primarily on market volatility (risk) tolerance to determine an investor’s portfolio structure.
It should be apparent that differing EROs will logically dictate different portfolio constructs as illustrated below.
*Retirement goal is to replace 70% of their exisiting income
How Firm’s Create Investor ERO-Driven Portfolios
Begin with identifying the Essential Returns Objective (ERO) that links the investor’s assets to their financial goals or liabilities.
The ERO Calculator not only calculates the return needed to accomplish a client’s goal but provides the flexibility to incorporate client preferences.
No other calculator in the world can effectively measure risk and reward relative to the investor’s Essential Returns Objective.
Every investor has a rate of return that will achieve their cash flow withdrawals (liability schedule) relative to their asset inventory and cash contribution (funding schedule).
We call this the investor’s Essential Returns Objective (ERO)
The ERO is the return necessary to achieve the investor’s goal.
The ERO identifies the investor’s risk/return profile allowing us to link investment goals to portfolio solutions.
It is the primary benchmark we use to measure performance, to analyze managers’ characteristics and dynamically monitor and evaluate the portfolio’s risk/return attributes.
Each strategic asset allocation is customized to each investor’s unique risk/return profile.
Here’s how firm’s use the ERO methodology in 4 Steps –
Identify the Essential Returns Objective (ERO) using The ERO Calculator.
It is the return that links the client’s assets to their liabilities and financial goals.
This is an ongoing review process as these dynamic liabilities, goals and market conditions change.
Determine the asset and style mix strategy needed to achieve the ERO.
Manager research and due diligence of Mutual Funds, Exchange Traded Funds (ETFs) based on your firm’s security offerings.
The ERO Optimizer quickly identifies active managers who consistently demonstrate an ability to outperform their style benchmarks on a risk adjusted basis.
Optimize the combination of both active and passive managers to meet or exceed the investors’ ERO.
The ERO Optimizer identifies the actual style blends of each active manager and then blending passive management where suitable to best align the portfolio to its intended asset allocation recommendation to achieve the investor’s ERO.
Monitor and rebalance the portfolio for dynamic market shifts or changes to the client’s ERO or financial situation.
The strategy remains aligned with goals of the investor.
This effective procedure enhances the probability of meeting or exceeding the investor’s Essential Returns Objective (ERO).
Each custom constructed portfolio seeks to achieve a distinctive ERO and utilizes a wide diversification of fixed income investments, money market vehicles, passive exchange traded funds, and active mutual funds.
The ERO approach allows firms to focus on the individual’s or institution’s ERO, and leverage ERO’s revolutionary advancement in the modern evolution of portfolio construction.
Your firm is strategically positioned to build more effective custom portfolios for better portfolio performance with less portfolio risk for investors as they continue to grow assets under management.
Talk to us to see how you can leverage the ERO technology.