Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Handicaps are a simple, explainable, and uniformly applicable measure of a golfer’s prowess. The handicap works irrespective of the location (e.g., if the play is at Pebble Beach, a public course or at the Old Course in Scotland). Every golf course is different, complex and littered with a myriad of choices, but the handicap unifies the courses, players, conditions, et al. Investment management is no different. Much like every play on a golf course, financial markets present their unique set of navigation challenges.
We propose a golf-inspired advisor assessment framework with a scorecard, fairway average and handicap as performance measures to quantitatively assess an advisors’ investment performance. The scorecard measures the play-by-play performance of an advisor in relation to a benchmark at each interval of the evaluation period (as in each hole of the course). The fairway average measures the propensity of an advisor to take more or less risk than the benchmark (as in the shot selection for the course layout). And finally, the handicap measures the advisor’s performance across periods that can be looked at as regimes (as different courses or periods).
Our proposed measures not only assess the advisor’s ability to meet or beat the target objective, but also sheds light on the advisor’s approach to the green (pun intended!). Golf greats would know best, but we find that the approach to the greens, as also captured in the scorecards for each hole, is a critical component to a better handicap. As with golf, the lower an advisor’s handicap, the better the advisor’s performance over the evaluation periods.
The advisor assessment framework has some immediate advantages. As with golf, the framework is driven by the market (as in the course) and its data needs are limited to the advisor’s performance. When applied uniformly, it normalizes the playing field to evaluate all advisors on a similar basis via the scorecards. As with the slope or course ratings that normalize the difficulty of golf courses, markets present themselves as regimes, and the performance of the advisors during specific regimes can be accessed via discrete plays on the scorecards and collectively as a handicap. Participants have their own approaches, possibly via club selections (or equivalent risk selection), to address the course layouts, and these can be assessed via their fairway averages. Finally, the advisor assessment framework construct is very flexible and can be easily applied across portfolios, for each client risk profile mapping, on a gross or net basis, with or without client nuances, etc. Overall, each client may have their nuances, but in the end, the financial performance should be measured against some set benchmark/objective and be explainable, which is facilitated by the simplicity of the advisor assessment framework.
Measuring the handicap
The advisor assessment framework needs the performance of the advisor and an objective as data inputs. Illustration 1 compares the performance of an advisor with an objective as represented by a (60% SP500 TR US + 40% US Agg Bond TR USD) blend benchmark.
Once we set up this relationship, as shown in Illustration 2, setting the variance thresholds around the benchmark performance can set score expectations for the advisor’s performance.
This scorecard relates the frameworks of golf and investment management. Assume the same advisor is being assessed along with four others on December 31st, 2021. Illustration 3 shows that the five advisors have near similar first-order risk-return profiles (return and volatility are calculated using data from 12/31/2020 to 12/31/2021).
An application of the advisor assessment framework shows that advisors 2 and 3 took less risk by playing more on the fairway (note there were times they deviated more than others), had relatively less erratic score cards (direct consequence of lesser fairway play) and a consistently lower handicap.
This simple framework illustrates how much better or worse the advisor is actually doing versus the benchmark (at each interval and in total), the path profile across the intervals, performance across market regimes, one of peaks/troughs and so on. In golf, generally would you prefer taking advice from a 30 or a 10 handicap? Similarly, given this setup and keeping other considerations aside, we should in theory listen more to advisors 2 and 3 on how to approach the greens (!).
Need for the handicap
Some advisors have a keen eye on negative performance as they are punished more via potential loss of accounts or challenging conversations for losing streaks than they are rewarded for out-performance. Some advisors keep an eye on the outliers, as those are more difficult to explain to certain clients.
Overall, more comfortable discussions require setting up an objective function and the performance around them. In addition, some pertinent questions include whether the recent performance was in line with expectations or a deviation from the norm, how it compared to others, if it fit a pattern, etc. The questions concern (a) expectations around the advisor’s ability to navigate the objective, and (b) how well did the advisor perform relative to the objective. The advisor’s performance communications, including track record, batting average, information ratio, etc., give point-in-time and nuanced assessments that arguably put the assessment emphasis back on the client. This makes the evaluation of the advisors, for trend, relative comparisons, path profiles, situational capture, etc., difficult or open to interpretation.
Researchers and industry publications have shied away from quantitative ways to assess an advisor’s investment performance, as each client is considered to have unique needs and there is a lack of uniform or auditable data. Therein, asset and portfolio performance measures are used. Depending on the sophistication, those range from simple to requiring complex financial engineering skills. Yet, although each client’s expectation and profile are unique to the family or individual, the planning profession has accepted the adequacy of a psychometrically based questionnaire for stratifying clients’ risk-return profiles within a few standard outcomes. Similarly, we think there is a need to uniformly supplement the qualitative advisor assessments with explainable quantitative metrics, whether they be from the industry publications or others.
We believe that the advisor assessment framework is an explainable measure that supplements insights by leveling the playing field. The simple premise is that the score ranges as distances from the objective function (benchmark) at each interval (positive or negative) over the evaluation periods can give uniform insights into the ability and path profiles of the advisor’s investment recommendations and overall performance. This assessment extends to any type of recommendation, is not data hungry and can be applied easily.
As with golf, markets have the ability to level the ego and handicaps!
Dr. Ali Hirsa is a professor at Columbia University and Satyan Malhotra is the CEO of ASK2.AI, a FL-based research and technology company. In the technical paper i, we provide detailed financial engineering and mathematical nuances for setting up the framework and give numerical examples for all mutual funds, ETFs and sample portfolios.
i Hirsa, Ali and Klinkert, Federico and Malhotra, Satyan, What is Your Investment Advisor's Handicap? (May 2, 2023). Available at SSRN: https://ssrn.com/abstract=4436113
More Buffer ETFs Topics >
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
