Here, Bill McBride and Jeff Schwartz of New Jersey-based Markov Processes International outline why they believe quantitative analysis will become a stronger piece of the advisor’s fiduciary mandate.

McBride is executive vice president and Schwartz is president at MPI, which is a provider of investment analytics, research and reporting software and services to the investment industry globally.

Famly Wealth Report doesn't necessarily share the views outlined below but is grateful for the right to publish them and welcomes reader responses.

With expectations for central banks to maintain rates at historically low levels “for some time,” muted long-term return forecasts for traditional asset classes and volatility to remain elevated, wealth managers are increasingly allocating client portfolios to alternatives.

According to McKinsey’s seminal asset management report from 2014, while alternative assets are growing at a rate twice as fast as traditional investments, retail, or liquid alternatives are growing 50 per cent faster than the broader alternatives category. While liquid alternatives fund flows slowed in 2015, we view this as an anomaly amidst the longer-term trend. The expansion and evolution in the product sets now being used by wealth managers means fiduciary best practices will likely adapt to the challenges posed by the complexity and opacity that are characteristic of alternatives.

With advisors’ increasing usage of alternatives – both retail and private segments of the product universe, depending on the client and desired exposure – they are being tasked with better understanding individual product behavior as well as the net effect of these strategies, and the entire alternatives bucket, on the total investor portfolio. Vetting and managing the new alternative vehicles and strategies requires deeper approaches less commonly employed in the wealth segment to date. With alternatives, reliance on factsheets and brochures produced by the fund manager and/or product sponsor, as well as scrutiny of any regular positions filings, is not enough to select and monitor the best products for clients. Inherent complexity of non-traditional strategies makes it exceptionally difficult to understand what an investor may actually experience and what impact allocations can then have on a portfolio.

Guidance on best practices can be gleaned from pensions and endowments and foundations in the US, global sovereign wealth funds in Europe and home office research teams at many large banks globally. These institutions, which have long been allocators to alternatives, have implemented quantitative factor analysis to supplement position-based analysis. Such returns-based methods can provide an understanding of the drivers behind strategy and/or portfolio performance that can be particularly insightful with alternatives, which may use derivatives, leverage, illiquid instruments, higher frequency trading and a relatively high volume of holdings. All of this challenges positions-based analysis for due diligence and risk management purposes. For these reasons, at leading institutions, quantitative analysis has become bedrock for manager evaluation and risk management – of managers, asset classes, strategies and the entire portfolio – for some time.

While the advisor's fiduciary duty does not outright declare practitioners must institute quantitative analysis in their investment process, the increased complexity of today’s product set and advancements in portfolio strategies makes it all the more valuable. As such, we expect that quantitative analysis will only become more important to regulators, and discerning clients alike, as a key piece of the advisor’s fiduciary responsibility.

Complexity may be highest with private hedge and private equity funds, but that doesn’t mean retail or liquid alternatives provide investors a clear looking glass. Even though there has been a rush by alternatives managers – and traditional long-only firms alike – to launch registered ’40 Act and UCITS products, full transparency does not align with managers’ interests in delivering expected and/or differentiated performance. Less than perfect disclosure requirements, which can lead to differing interpretations of the size and portfolio impact of derivatives, leverage and short positions, and the infrequency of holdings disclosures, reported with a significant lag, afford fund managers a level of opacity that can challenge advisors when making investment decisions.

The short histories of the majority of products and therefore peer groups also make quantitative analysis more valuable since advanced techniques can begin providing credible results with as few as a dozen data points. Indeed, quantitative analysis is the only option for high-frequency monitoring of dynamic strategies, which is of increasing importance in periods of heightened volatility.

A good liquid alternatives example is the fast-growing non-traditional bond segment, which contains unconstrained and long/short bond funds. These strategies typically afford the manager a broad investment mandate with tremendous leeway to select securities across sectors and geographies free of a defined benchmark; effectively, such strategies are more akin to absolute return hedge funds than bond mutual funds. Over the past year, increased volatility in credit markets, dislocations in commodities, wide currency swings due to divergent monetary policies globally and rate movements that have defied consensus, funds within this segment have delivered a tremendous range of outcomes. Wide intra-month swings, vast holdings statements with ample derivatives usage and rapid strategy shifts reacting to volatility make quarterly holdings reports of little assistance for advisors deciding which fund(s) may be best positioned to provide the sought after absolute return with the intended lower rate risk – and, further, how that allocation can impact the broader portfolio.

While categories such as non-traditional and multi-sector bond, long/short equity and market neutral are the obvious candidates in the liquid alternatives universe deserved of extra scrutiny, several anecdotes from the past year in seemingly less exotic, and even core, fund categories provide evidence that quantitative analysis can bolster advisors’ investment processes no matter the supposed sophistication of the product under the microscope.

The lateral asset flows in total return bond funds in the core intermediate-term bond fund category caused many to re-evaluate products long deemed standard placements. Derivatives usage and lists of positions approaching and/or exceeding five figures caused many to realize greater care, including understanding the top-down behavior, when allocating to these products was warranted. Poor performance of tactical allocation funds marketed to protect against the downside made advisors recognize that the fast trading strategies and multi-asset portfolios of these products rendered bottom-up holdings-based analysis less helpful than once thought. And most recently, dislocations in the high yield corporate credit segment have forced investors to reconsider risk and liquidity levels of their managers who have perhaps traded too much liquidity for higher yields and differentiated returns. Here, too, advisors would do well to understand the factors driving the performance of funds.

Risk parity, once the province of only the top hedge fund advisors, has become widely available in liquid alternative format and increasingly in a target date structure. The complexity, range of assets, and a wide dispersion of returns suggest some disparity, and advisors would do well to better understand product design and manager strategy. Improvements to comprehension of smart beta strategies, increasingly ubiquitous and complex with growth in multi-factor products, can be gained with quant analysis. Regressing rules-based strategies against factors can better determine exposures, including changes and risks due to reconstitutions and rebalancing, as well as how products may interact within the broader equity slice of an investor portfolio.

Indeed, funds in traditional categories are not immune to behavior more characteristic of alternative strategies. Quantitative analysis can help to identify such instances, assess behavior of outliers and associated risks.

Of course, quantitative analysis is not without its shortcomings. Factor correlation can deliver confusing results. Some strategies capable of adding significant value in a portfolio setting may regularly defy high conviction modeling in a quantitative lens. This doesn’t mean they are not worthy of investment. Variation in results when utilizing different data frequencies and/or start dates are common and require care when interpreting. Quantitative analysis can be very insightful and is an important complement to more traditional methods of analysis, but it is not advised to use it in isolation.

Thoughtful adaption of proven quantitative practices within the investment advisor space will help practitioners fulfill their fiduciary duties as currently interpreted and favorably position themselves ahead of potential future regulatory changes. For instance, with the potential for extending the fiduciary duty to brokers and private bankers in the US, quantitative analysis can help advisors differentiate their offering in an environment marked by higher competition and increased scrutiny from both investors and regulators.

Factor analysis is not a panacea in overcoming the challenges of complex investment strategies, but it can provide an additional perspective that complements other types of analysis and rewards advisors and their clients over the long-term. For these reasons, we see it becoming a key piece of the advisors’ fiduciary duty in the future.