New portfolio-risk tools have been created specifically to integrate with FinaMetrica and map a client’s risk tolerance with an actual (and revised) portfolio. I looked at two such tools to see if they can help advisors improve client results – or if they can help
win new business. Here’s what I found out.
The FinaMetrica risk profiling tool is the gold standard for evaluating the risk tolerance of your clients – the only one on the market that is justified by academic psychometric research and peer-reviewed studies. Its goal has always been not to dictate what portfolio you create for clients, but to start a good conversation about how clients feel about downside risk, and at what point they’re liable to sabotage their financial future by bailing on a long-term investment policy at the wrong time.
Nevertheless, advisors have been asking for a quick, convenient way to map the FinaMetrica risk score to a particular portfolio – for two reasons. They’d like guidance on how to revise a prospect’s (or client’s) current holdings to more closely match the client’s ability to tolerate downside volatility. And they’d like a way to evaluate portfolios and see how appropriately they (or their advisors) are managing their assets in light of their tolerance for downside volatility.
The requests have been answered with two new products that help translate a person’s FinaMetrica score, from 1-100, directly into specific portfolios using the advisor’s own buy list. Both will translate current portfolios into risk scores that match the FinaMetrica grading system. And both offer very powerful portfolio-building tools that make it relatively easy to modify a client’s holdings not only to match his/her risk tolerance, but also to create a more stable, durable, efficient mix of assets using your overall buy list.
Interestingly, the two products take different approaches to the same problem.
RiXtrema: Downside scenario learning
Let’s start with RiXtrema, which has been building out its FinaMetrica integration since late last year. RiXtrema is constructed around some of the most sophisticated scenario tools you’re likely to find anywhere, which start with the spectrum of future scenarios themselves.
“The scenarios come from our advisory board, which includes hedge fund managers and people responsible for managing multi-billion dollar pension portfolios,” says RiXtrema president Daniel Satchkov. “They, and our institutional customers, tell us the potential economic situations that they’re most interested in preparing for, and we make that intelligence available through the product as a form of high-level crowdsourcing.”
Once the institutional portfolio managers have identified the scariest and most interesting possible future scenarios, the company’s quants, using proprietary algorithms, evaluate how each scenario would impact hundreds of different factors. Then they explore how the changes in those factors would impact each of many thousands of different investments.
The result is a most likely downside figure for any given portfolio for each scenario – which can actually be a huge negative return (think: return of 2008) or a slightly positive return, depending on how well the portfolio is positioned for each scenario. The average of the three nastiest projected losses drawn from all the scenarios becomes the potential loss figure that is used to map a portfolio to the FinaMetrica score.
How does it work? An advisor can log onto www.portfoliocrashtest.com, the site created as RiXtrema’s standalone FinaMetrica integration, enter a client’s portfolio manually or using the Quovo account aggregation system, and immediately you can see how it compares with the client's risk tolerance. So, for example, the client with a $1 million portfolio might have taken the FinaMetrica questionnaire and scored a 49 – roughly average risk tolerance.
When her portfolio is entered into RiXtrema, the downside for the worst case of the various scenarios – the Federal Reserve Board’s “severe” scenario – would result in a 58% drop in U.S. stocks. In her current portfolio, this client would experience a total top-to-bottom loss of just under $438,000. A repeat of 2008 would result in a $329,000 downside. If Chinese corporate debt were to implode (aren’t these scenarios interesting?), the portfolio is projected to drop $305,000. (Interestingly, a Brexit scenario was projected to shave 17.3% off the portfolio’s value over the short term – a forecast which proved to be unrealistically dire, given the mostly positive performance of U.S. stocks since June 23.)
RiXtrema’s quants have mapped this client’s current portfolio to a FinaMetrica score of 64, which might be a bit risky for her.
What to do?
You can bring the current portfolio into conformity with the client’s risk tolerance by moving a slider at the top of the screen from 64 to 49. RiXtrema will sort through everything the advisory firm has included on its buy list – and, of course, everything in the current portfolio – and show the buys and sells that would modify the existing portfolio to one that would be projected to lose only $284,000 in the worst of the various scenarios that sophisticated investors are worrying about.
In this case, a 2008 collapse no longer makes the top three; now an aggressive Fed tightening scenario is projected to shave $204,000 off the portfolio’s value, and the Chinese corporate debt scenario would lose $201,000. (Brexit’s loss was projected at 10.9% with this less aggressive portfolio.)
Presto! The client's portfolio is a 49, which matches the client's FinaMetrica score.
Can it really be that easy? Advisors will want to examine the tax implications of the various buys and sells, and they may want to play with the recommendations a bit, which they can do easily on the RiXtrema system. They can compare different asset mixes to see how they hold up under all of the other scenarios that are listed, in order of amplitude of loss, at the bottom of the page.
They can also modify the portfolio by moving a slider to adjust the maximum loss in the RiXtrema scenarios. If the client is unwilling to think about a $284,000 hit to her portfolio, will she be open to the possibility of a $200,000 loss if the market goes through the worst of various huge trauma scenarios? As you move the slider to maximize the loss at this level, you see at the top of the screen where the resultant portfolio would fall on the FinaMetrica scoring system – in this case down to 38.
Satchkov believes that you should not stop here, and points to another section of RiXtrema’s Portfolio Crash Test tool that might enhance your conversation with clients. Here, you can explore the same portfolio based on its ability to sustain the client’s lifestyle during retirement – or, in the case that Satchkov demonstrated to me, you can look at portfolios with risk scores of 38 and 54 side-by-side, on a graph that shows how much money they will have each year in the future, based on capital market assumptions.
The graph shows the two portfolios increasing their value over time until you start stress testing. The first thing you can do is use a little marker to insert crashes. “We don’t know when a crash will happen,” Satchkov explains. “But we think it’s prudent to assume that one will happen every 15 years.”
Over the 30-year time span of the two portfolios, Satchkov uses the marker to insert two crashes, one in the first year of retirement, another in year 15. The 54 portfolio, of course, drops more than the one with a FinaMetrica correspondence score of 38; one drops the client’s portfolio value to $720,000, the other to $840,000. The riskier portfolio then gains ground more quickly before falling harder again at the next crash. Interestingly, the more conservative portfolio ends up with a higher after-inflation value at the end of 30 years.
It takes less than two seconds to move the crashes to different years, but before you do, you might consider adding inflation-adjusted drawdowns to the calculations. Satchkov recommends that you move the slider from zero to different amounts and see the maximum annual inflation-adjusted drawdown you can take by edging the slider forward to the point just before the portfolios hit zero in the last year of the client’s time horizon. Then you stress test by moving the crash sliders around. (You can also add or subtract custom cash flows to account for, say, an expected inheritance or a major purchase during any of the years.)
The only downside with a tool this powerful is that you find yourself spending way more time than you expected, moving crashes around, adjusting cash distributions, and marveling at how the 4.5% rule Bill Bengen proposed so long ago is still relevant to this sophisticated scenario/factor-based analysis.
Satchkov thinks that this second step starts to address the real risk – of running out of money – that clients face. “The risk level should be in the context of the client’s goals,” he says. “It could be that, once you go through this exercise, a 59 portfolio is actually more appropriate for a client than a 49, once they see how the cash flows play out. Other times, the client might not need to take as much risk as the FinaMetrica score might indicate.”
MacroRisk - Portfolio risk tools
The second tool that you can use to map portfolios to the FinaMetrica score is MacroRisk Analytics, which is a different quant-based system built around the relationship between the movements of 18 key economic factors and investment portfolio returns. MacroRisk has created a standalone FinaMetrica portfolio risk analysis tool that can be found at www.PortfolioRiskTools.com.
Once again, I gave myself a risk tolerance score of 49. The advisor inputs a client’s portfolio from a spreadsheet or by hand (there is no Quovo integration here) and selects the risk correspondence tool from a drop-down menu. This gives you the current portfolio’s risk tolerance score, as calculated by MacroRisk’s algorithms, and the holdings are listed top to bottom. Below the list of holdings, you find a variety of statistics related to the total portfolio that will delight the more quantitative-minded advisor: CAPM, beta, down-market Beta, Sharpe ratio, Sortino ratio, and “stoplight” statistics, which are proprietary to MacroRisk and are designed to evaluate how likely it is that the portfolio as a whole will have an above average Sharpe ratio over the next five years. (Green means yes, yellow means maybe, red means probably not.)
You can add or subtract investments or move sliders to modify the portfolio, and every change maps immediately to the FinaMetrica risk tolerance score. It took about 30 seconds to nudge my 43 portfolio by trial-and-error to a risk profile of 49; just move any one slider forward or back and the other holdings will adjust in equal measure in order to keep the total percentage at 100.
With each slide, in real time, you’ll see the impact on the portfolio’s beta, Sharpe ratio, Sortino ratio, stoplights, etc. This actually added some time to the process, because as I was sliding myself closer to my FinaMetrica score, I was also watching the efficiency metrics, and eventually I started making adjustments which had little effect on the portfolio’s overall risk, but which nudged my beta downward, and gave me green stoplights and a higher Sharpe ratio.
When you finally arrive at the portfolio you want, the system will create two different reports that you can deliver to clients, one more detailed than the other. The simpler summary version (the one you’re most likely to use with most clients) starts by comparing, between the current and proposed new portfolio, the standard Beta, down-market Beta, Sharpe ratio, Sortino ratio, MacroRisk level and an economic climate rating (basically how well positioned the portfolio is to absorb shocks from economic shifts along those 18 economic factors). The summary report also, of course, displays the risk tolerance correspondence score for the original and new portfolio, and in each case, it calculates the difference between the two.
The holdings, current and proposed, are listed, and here you see the differences in shares, which tells you what you’d need to buy or sell into or out of the original portfolio in order to make it conform to the client’s FinaMetrica score. You also see differences in weights for each element of the two portfolios.
Each holding also has its own individual risk-tolerance correspondence score, which confused me at first. Shouldn’t a risk number only apply to the portfolio as a whole?
“Some people will focus on an individual holding that has gone down in an otherwise stable portfolio,” explains Mike Phillips, the Cal State Northridge professor of finance, financial planning and insurance who originally created MacroRisk for institutional clients before making it available to advisors. “Even though the portfolio might be unchanged overall, that kind of client will focus on that one investment. So we give the advisor a chance to see which holdings might trigger that response.”
The comprehensive version of the report is designed for your engineer clients who might want to see the Modigliani statistics, batting average, maximum drawdown, upper and lower standard deviations and 12-month trailing returns. If the client is confused about what these statistics mean, she can click on a little question mark next to each of them, which will bring up an explanation.
And, like RiXtrema, both reports show the impact of a downturn on the current and proposed portfolio, both in percentage and dollar terms. In the final portfolio I created, if the market fell by 10.6%, the downside beta measure indicated that my portfolio would fall by 6.1%. As a FinaMetrica 49, I like that safety.
Portfolio results
To test both systems, I used an unrealistically simple set of investments, but both RiXtrema and FinaMetrica allow you to model any and all of tens of thousands of individual stocks, open- and closed-end funds and ETFs (but not TIPS, SPIAs or DIAs). In my trial, I ended up with slightly different portfolios from the two systems, but as you can see below, they were not dramatically different. Both tended to keep my eight proposed ETF holdings broadly diversified. Simple as they are, these portfolios might actually hold up pretty well in the real world:
|
Fund
|
Rixtrema %
|
Macrorisk %
|
|
Vanguard Long-term Bond
|
15
|
15.33
|
|
Vanguard MSCI EM
|
10
|
13.53
|
|
Vanguard Intermediate Bond
|
10
|
15.33
|
|
Vanguard HealthCare
|
10
|
14.15
|
|
Vanguard Small Cap
|
15
|
16.40
|
|
Vanguard S&P 500
|
20
|
13.53
|
|
Vanguard Dividend Appreciation
|
20
|
13.53
|
Cost? You can buy the RiXtrema system or MacroRisk’s Portfolio Risk Tools bundled with FinaMetrica at a discounted price. MacroRisk’s portfolio evaluation tool costs $900 a year, and you get a 33% discount on the FinaMetrica product when you sign up. If you already have a FinaMetrica license, then you can purchase MacroRisk’s portfolio evaluation tool for $600.
The RiXtrema subscription ranges, depending on the features, from $150 a month to $300 a month, and RiXtrema offers the same 33% discount on the FinaMetrica service.
Discussion points
I’ve been very skeptical of FinaMetrica’s competitors in the risk-tolerance space, in part because I’ve never seen any academic justification for their processes, in part because they’re being sold as a marketing tool: You show a prospect the discrepancy between her risk tolerance number and the corresponding number to her portfolio, and then suggest that she’s working with the wrong advisor.
Risk-tolerance assessment is not about marketing and replacing what might be a perfectly good advisor relationship, but about helping clients better understand themselves and avoid bailing out of a sound long-term investment policy.
But I’m curious what you think. The combination of FinaMetrica with RiXtrema and MacroRisk Analytics will do the same marketing job that you can buy with some of the risk-tolerance competitors, with the added bonus of providing some of the most sophisticated portfolio building tools on the planet.
What IS the highest and best use for the ability to compare risk tolerance with the riskiness of the portfolio? Is it marketing, or some form of client service?
Bob Veres' Inside Information service is the best practice management, marketing, client service resource for financial services professionals. Check out his blog at: www.bobveres.com. Or check out his Insider's Forum Conference (for 2016 in San Diego) at www.insidersforum.com.
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win new business. Here’s what I found out.
