Treat Customers Fairly
This is a core element in the way we behave and transact business.
Our commercial dealings always take full account of the principle of Treating Customers Fairly.
We aim to provide full information to our clients covering the benefits, risks and costs of any recommended product or service provided.
Our intention is to inform in a clear, fair and not misleading way so that our clients can understand what they can reasonably expect from service and from any policy or plan recommended.
We aim to honour all commitments we make to our clients, if any dissatisfaction should occur we will investigate the underlying cause and take appropriate action whenever necessary.
Our reputation is important to us, therefore, client satisfaction is vital and Treating Customers Fairly is implicit in all our dealings.
We take our independence very seriously. This is why we are categorised as Independent Financial Advisers providing a whole of market service and have no ties to any banks, insurance companies or investment managers. We act for our clients and all that we do professionally is aimed at delivering their financial goals in the most efficient and cost effective manner.
Some financial advisers and wealth managers try to blur the distinctions between what they do and true independent financial advisers. We have therefore set out below a short set of questions and answers which should make the differences very clear.
What are the differences between Independent Financial Advisers and those who work for Banks and Insurance Companies?
Question: Who does an insurance company salesman work for?
Answer: The insurance company
Question: Who does an independent financial adviser work for?
You. They are your agent, not that of any provider. This is actively monitored by the regulator.
Question: What products can an insurance company salesman sell?
Answer: Only those of the insurance company (and now sometimes products from a limited range of other companies).
Question: What products do independent financial advisers sell?
Answer: Whatever is available on the market. They are required by the regulator to justify their provider and product recommendations and this is actively monitored.
Question: What can an insurance company salesman do when his products under perform?
Question: What can an independent financial adviser do when his products under perform?
Answer: If necessary, assist you to dispose of them and find something else from the whole of the market out there.
Question: What advice can an insurance company salesman legally give you about products from other companies?
Answer: None. If you have an existing portfolio they cannot monitor it or comment on it since they are not qualified to do so. What do you do with that policy that you bought 20 years ago from XYZ Life? Well don’t ask the current salesman from St. Jades. He can’t advise you on this, although he may try to make out he can.
Question: What advice can independent financial advisers give you about all of the products on the market?
Answer: Whatever you need to know.
Question: What can an insurance company salesman do when he doesn’t have a product that matches your need?
Answer: Nothing – well actually he can refer you to an independent financial adviser.
Question: What can an independent financial adviser do when he doesn’t have a product that matches your need?
Answer: N/A He has the whole market to choose from.
The above has only considered product selection. Actually good independent financial advisers do a great deal more. A good IFA will not start to talk about products or even begin to think about them until he has found out about your values and financial goals and established your current position.
Evidence Based Investment
We believe that an approach based on academic research should be adopted to ensure that investors achieve the level of market return that they are entitled to, given the level of risk that they wish to take. Far too many investors push money into actively managed funds which fail to add any value. We therefore adopt a different approach, which is set out below.
Markets are efficient
Our core belief is that markets are “efficient.” The efficient markets hypothesis holds that markets are full of people trying to make a profit by predicting the future values of securities based on freely available information. Many intelligent participants compete to trade at a profit. The price they strike in trading a share is the consensus of their opinions about the share’s value. Since the price is the same for everyone, so is the value. The price the market strikes is therefore based on all the available information about a share, everything the investors know that has happened in the past and everything they predict will happen in the future. In this sense, markets assemble and evaluate information so effectively that the price of a share is usually our best estimate of its intrinsic value.
Prices are not always perfectly correct, nor is that a condition for market efficiency. The consensus view of investors can temporarily result in prices well above or well below a share’s intrinsic value. The only condition efficient markets require is that a disproportionate number of market participants do not consistently profit over other participants. Since “mispricings” tend to occur in both directions and since managers seem to over- and under perform with random frequency when adjusted for risk and costs, markets seem to be efficient.
Optimum Portfolio Structure
The optimum portfolio structure is based on, and supported by, a substantial body of academic research into the sources of investment risk and return which has reshaped portfolio theory and greatly improved understanding of the factors that drive performance.
Three Equity Factors
Market: Shares have higher expected returns than fixed interest.
Size: Small company shares have higher expected returns than large company shares.
Price: Lower-priced “value” shares have higher expected returns than higher-priced “growth” shares.
The notion that equities behave differently from fixed interest is widely accepted. Within equities, it has been found that differences in share returns are best explained by company size and price characteristics.
Two Fixed Interest Factors
Maturity: Longer-term instruments are riskier than shorter-term instruments.
Default: Instruments of lower credit quality are riskier than instruments of higher credit quality.
In the realm of fixed interest, two factors drive returns. Though these two factors characterise interest-sensitive investments, they do not have substantially stronger long-term expected returns. Therefore, fixed interest is best kept short in maturity and high in credit quality so risk exposure can be increased in the equity markets, where expected returns are higher.
The Benefits of Diversification
One of the best-established methods of risk management in investing is diversification. The concept is simple: holding only one share in your portfolio makes you directly susceptible to its price changes. If its price plummets, so does your entire portfolio. Hold two shares instead and, unless they both plummet, the portfolio is still afloat. The key to diversification is the age old adage, “don’t put all of your eggs in one basket.”
The main point of diversification is to reduce risk rather than improve expected return. For many European investors, the MSCI Europe Index represents the first equity asset class in a diversified portfolio. Although this index is diversified in European companies, investors can benefit by adding further components. Take, for example, a portfolio that holds just European shares, a portfolio that holds international shares (ex Europe), and a portfolio that holds a third in both regions with a third in international bonds (Citigroup World Government Bond Index Hedged). The diversified portfolio has a substantially lower standard deviation – risk to you or I.
MSCI Europe Index: 18.6%
MSCI World Ex Europe Index: 17.7%
Balanced Portfolio: 11.7%
(Balanced Portfolio is one-third MSCI Europe Index Gross Div., one-third MSCI World ex Europe Index Gross Div., and one-third Citigroup World Government Bond Index 1-30+ Years Hedged. Data in USD.) MSCI data courtesy of Morgan Stanley Capital International.
Citigroup data courtesy of Citigroup Global Markets Inc. Performance data represents past performance and does not predict future performance.
This is the power of diversification: the whole is greater than the sum of its parts
The Importance of Asset Allocation
Capital markets are composed of many classes of securities, including stocks and bonds, both domestic and international. A group of securities with shared economic traits is commonly referred to as an asset class. There are several asset classes, all with average price movements that are distinct from one another. Investors can benefit by combining the different asset classes in a structured portfolio.
I believe investors should not only diversify across securities within an asset class, but also across asset classes themselves. This should include the full range of strategies: small and large stocks, domestic and international, value and core (growth), “emerging countries,” global bonds, and even real estate. Because the asset classes play different roles in a portfolio, the whole is often greater than the sum of its parts. Investors have the ability to achieve greater expected returns with lower standard deviations than they would in a less comprehensive approach.
However, because no two investors are alike, there is no single “optimal” asset allocation. Each investor has his or her own risk tolerances, goals, and circumstances that dictate the weightings in each asset class. In general, the greater the proportion of stocks a portfolio holds, especially small cap and value stocks, the more “aggressive” a taker of risk it is and the greater it’s long-term expected return.
Many investment managers either believe they can actively exploit “mispricings,” so they engage in traditional active management; or they believe they can do nothing to add value over benchmarks, so they engage in traditional index management. I believe in a different approach. This combines the broad diversification, low cost, and reliable asset class exposure of passive strategies and adds value through engineering and trading.
Academic research has shown that the three-factor model on average explains about 96% of the variation of returns among fully diversified professional US investment plans. Investing is therefore largely about deciding the extent your portfolio will participate in each of the three risk factors. In general, the greater the risk exposure, the greater the expected return.
Ethical Investment Approach
We recognise that a growing number of clients wish to apply ethical screening to their investment choices. Ethical screening means different things to different people and clients vary in the extent to which they wish to overlay criteria which are unrelated to investment performance when constructing their portfolios. Bridgewater will therefore offer a core set of ethical portfolios which are based on strict ethical criteria, which should meet the requirements of the clients with the most purist views.
In common with the main investment approach, Bridgewater aims to achieve a consistent, evidence based approach (as far as reasonably possible) and to use a common process for all of its clients. This enables a cost effective and efficient service to be delivered to clients. Bridgewater’s service pricing will therefore be the same for both sets of portfolios. As will be seen below, in respect of the ethical portfolios, a degree of hybridisation between the ethical and non-ethical portfolios is needed in order to ensure better risk: return consistency between the two types of portfolio. As this may breach the ethical requirements of certain clients three sets of model portfolios will be offered:
- Full (non-ethically screened)
- Pure Ethical
- Hybrid Ethical
Where clients require a more bespoke approach, Bridgewater will be able to offer this but, due to the substantial increase in work load at the level of the individual client, will need to agree a higher level of charges to cover the increased time spent on advice, implementation of transactions and ongoing reviews.
Investors need to understand that by applying non-investment performance related criteria on their portfolios they are likely to achieve sub-optimal risk: return performance. In layman’s terms this means that the portfolios may not generate the returns that would reasonably be expected given the risk taken and at the lower end of the risk spectrum, risk control may be less efficient. This must be understood and accepted before recommendations are provided and implantation is carried out.
The approach taken by Bridgewater is to stick to the core principles behind its main investment philosophy. This means that the high level split between equities and bonds and cash will be retained. The portfolios also maintain a UK bias to reflect the fact that most clients are resident in the UK. This should ensure that the variance of the ethical and non-ethical portfolios should be broadly similar. However, when selecting funds ethical screens are applied.
The consequences of this are that a more limited range of funds is available on which the initial ethical filtering is carried out and the funds which are available are, at least officially, actively managed from a stock selection and market timing point of view. This inevitably means that fund manager error will be present within the funds, which is absent from the main (non-ethically screened) portfolios.
Further implications of a purely ethically driven approach stemming from the limited fund range that is available are that Value and Smaller Company Equity funds are not available and the bond funds are longer dated. This means that it is not possible to apply the Value and SMB tilts that are present in the main portfolios and the level of risk control provided by the Short Dated Bond and Index Linked Gilt Index fund is not possible in pure ethical portfolios.
Bridgewater’s aim with the ethically screened portfolios is for them to have risk: return characteristics which are as close as is reasonably possible to the main portfolios. The primary measure of risk which has been used is standard deviation, which is a measure of fund volatility. The composite standard deviations of the main and ethical portfolios have been compared and for the more equity oriented portfolios, the characteristics are fairly similar. However, for the lower risk portfolios, the greater volatility of the longer dated bond funds in the ethically screened portfolios results in a material difference in risk.
Ethical Screening Criteria
Funds have been filtered first by reference to the ethical standards and then by their investment charactistics.
The ethical screening criteria are summarised below. Most funds apply the same positive criteria but vary in the extent to which they apply negative criteria (i.e. activities in which they will not invest). Bridgewater has therefore used the negative criteria. Some funds apply partially negative criteria, i.e. they allow them but to a limited extent. Where this is the case and there are other funds in the same sector which fully apply the negative standard, they will be selected in preference. The decision on which filters to use and their severity has, inevitably taken into account that fact that excessively strict criteria could result in the removal of all candidate funds from the shortlist. In order to avoid this, where necessary, a pragmatic approach, which sticks as far as possible to the ethical intent of the process, has been adopted.
The ethical criteria have been summarised below:
|Ethical Criteria||Filter Applied|
|Alcohol – Production||Exclude if possible but not essential|
|Alcohol – Sale||Exclude if possible but not essential|
|Animal Intensive Farming – Retail||Exclude|
|Animal Intensive Farming – Wholesale||Exclude|
|Animal Testing – Cosmetics and Toiletries||Exclude|
|Animal Testing – Pharmaceuticals||Exclude|
|Financial Services||Don’t Exclude|
|Gambling||Exclude if possible but not essential|
|Human Rights Abuse: Yes||Exclude|
|Nuclear Energy: No||Exclude|
|Tobacco: Yes||Exclude if possible but not essential|
Investment Screening Criteria
The funds which have been shortlisted using ethical criteria were then reviewed for their risk return characteristics and charges. In the latter case, account has been taken of the discounts which would be applied by the two main dealing platforms which are used by Bridgewater have also been taken into account.
In order to comply as close as is reasonably possible with Bridgewater’s fundamental philosophy that market timing and stock selection strategies are in general ineffective and therefore to be avoided, the main performance factor which has been reviewed is the funds Beta. This is its performance relative to the market. A Beta of 1 indicates that the fund moves in line with the market. Where it is more than 1 it moves by more than the market and vice versa. Funds with a Beta of 1 or less suffer less from fund manager error than funds with higher Betas. Therefore, wherever possible funds with Betas as close to 1 will be selected. Betas over 1, 3 and 5 years have been used wherever possible and a consistent rating, as far as possible, is sought.
It is worth mentioning that past investment performance has deliberately not been included as an investment selection criterion because it provides no meaningful indication of future investment returns. Even where individual fund managers have performed well, this tends not to be continued in future.
Cost is important but due to the limited range of funds which is available, this cannot be applied in an over-riding manner in order to avoid excluding all possible candidates. Investors who wish to apply ethical criteria will need to accept that their investments will cost more and that this will inevitably have a drag on potential performance.
The Bridgewater Ethical portfolios provide investors with the best of both worlds. They combine strong ethical screening with an overall evidence based approach to the construction of portfolios. This means that, when used in conjunction with our investment portfolio advisory process, clients should get portfolios which both satisfy their consciences and at the same time behalf in the manner expected given the level of risk that they are prepared to take.