Articles | November 9, 2023

The Advisor's Edge: Building Investment Platforms

What is an investment platform? While every organization defines it differently, the goal is always the same: to implement the specific asset allocation policy of the firm.

In this episode, Dave and Peter from Segal Marco Advisors’ Advisor Solutions Group lay out the basics of investment platforms: what they are, why they're not “one size fits all" and what to keep in mind when you go about the task of building one. They also discuss why it’s important to keep your platform flexible and customizable — for both advisor and client. Listen now.

The Advisors Edge: Building Investment Platforms

Podcast Transcript


David Pappalardo, Senior Vice President, Advisor Solutions Group
Peter Sullivan, Vice President


The Advisor’s Edge Podcast

A podcast for financial intermediaries, designed to keep you abreast of what’s new and what’s next in modern wealth management. In each episode, top experts in the field will share the latest intelligence on market trends. Asset allocation. Due diligence insights. And more. It’s part of our SMART series, highlighting new thinking from Segal Marco Advisors’ Research and Trends, helping you make more informed decisions


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Podcast transcript


Speaker: Welcome to Advisor's Edge. A new podcast for financial intermediaries designed to keep you abreast of what's new and what's next in modern wealth management. In each episode, top experts in the field will share the latest intelligence on market trends, asset allocation, due diligence insights, and more. It's part of our smart series highlighting new thinking from Segal Marco Advisors research and trends, helping you make more informed decisions. This podcast provides information from reliable sources, but no guarantee is given for its accuracy. It is for general education purposes only, and not intended as legal, tax, accounting, or investment advice. It does not constitute an offer to buy or sell securities or investment products. Consult your own advisors before making any decisions. Segal and Segal Marco Advisors are not responsible for any actions taken based on this podcast. Now let's dive right into today's episode.

David Pappalardo: Hello everyone. This is David Pappalardo from The Advisor Solutions Group. I'm joined by my colleague Peter Sullivan, and we're here for the second episode of the Advisor's Edge Podcast. We're here to share our perspective and our experience on all that we do within the financial intermediary channel, and hopefully you'll find today's episode on building investment platforms interesting. So before we really jump into some of the details, I think we need to create a baseline of what a platform is. There's quite a bit of a difference of opinion of what that actually means.

From our perspective, it's simply all of the investment options that a firm is offering to their advisors and by extension their clients. So it's a recommended list, it's an advisory list, a list of your best ideas. Now, where Peter and I will jump into some of the details here is that it's going to be quite different from firm to firm. Sometimes these lists are very long, sometimes they're very short and very focused. It really depends on the needs of the firm. So there's not a standard platform or a standard list of recommended strategies. It really is going to be determined completely, at least from our perspective, by what the firm needs that we're working with. And I think that's probably a good place to jump off. And I'll turn it over to Peter. Peter, with some of the different clients that we work with, what are you encountering when you have these initial conversations about building a platform or having us review their existing platform?

Peter Sullivan: Well, usually what we encounter is a wide range of platforms and with widely different approaches, comprised of different managers, different funds, different vehicles, different asset classes, and each one in our experience is unique. Because every organization, every enterprise, every business that we're talking about here that needs an investment platform is different. And those differences are based on the philosophy, the approach of each organization, each business, how they're staffed, how they came together. The investment platforms in a lot of ways represent a unique mix of people and professionals with different backgrounds so that they are widely different.

I think, Dave, typically we start with defining a manager platform and investment platform as really, again, a group of managers, a group of mutual funds, separate account managers, different vehicles ultimately curated in some process, but with one specific goal, which is to implement whatever the broad investment policy is of the firm. Ideally, it's really the asset allocation policy, that asset allocation model, that approach to investing among different asset classes in this investment platform is that curated list. A series of tools in one big toolbox that really is intended to implement that specific asset allocation policy.

The other thing I would say about the investment platform is, and again, why it's so different is it also represents really the firm's business, the enterprise and the effort. Essentially what it represents is that sense of governance. How decisions are made from the bottom up. It's hiring and firing decisions for individual funds and managers. From the top down, it's governance. How does an organization meet the requirements around fiduciary responsibility, having a standard of care in the investments that it recommends to its clients, and how does a firm make decisions broadly in meeting that standard of care that's associated with that fiduciary responsibility. From the bottom up, it's that hiring, firing decision but from the top down perspective, it is how do we effectively implement these asset allocation of individual clients and do so efficiently and effectively?

David Pappalardo: Thanks Peter. And I think what might be useful for listeners is to really give somewhat of an example of what we typically encounter. So certainly what we might have someone come in the door with is a question of what is the ideal platform? And at this point, obviously they will have given us access to the strategies that they're using. I would say generally speaking, we're looking at firms that are probably using somewhere between 30 and 50 strategies. Sometimes it's less, sometimes it's more, but that's probably a good medium point. And then I think a lot of times sometimes managers that might not have the due diligence resources that a firm like Segal Marco has, might think that we have this magic black box where we turn a key and their platform becomes magically transformed with ready-made solutions. And I think in those cases, what we try to impart is that it really comes down to, first of all, analyzing what the platform that has already been built looks like and I think even more importantly, why does it look that way? Was it built that way on purpose or is it just the amalgamation of lots of little decisions over the course of years, whether it's new clients coming in the door and other client perhaps leaving, and then it's a bit of a mismatch of different strategies.

So I think that's a starting point to understand, here's your platform and we can look at it, but let's talk a little bit beyond that. Why does it look this way? Was it built this way purposefully? A good example might be we've had clients that have come to us and we've looked at their platform and it doesn't have any commodities, no energy exposure. And in talking to them, we learned that it was actually done on purpose because most of their clients have very large holdings and have accumulated their wealth in those industries. And so they did not want to essentially double dip in those investment asset classes, which from our perspective certainly made sense. But again, it's a question to ask because there are always going to be sensitivities around where people invest, and every firm really is different. So there's not always a turnkey solution. You want to start where you should start, which is at the beginning in understanding why the platform looks that way and that bleeds over into the firm itself.

As Peter mentioned, what's the philosophy and the governance of the firm? Maybe they go about building their portfolios and implementing them in a way that certainly needs to be considered. It might be different than all the other clients that we've dealt with over the years. So it's really important to start at ground zero and understand the underpinnings of the firm before you get into the second and third steps, which Peter can talk to certainly, but looking at asset classes and vehicles and minimums and trying to understand the nuts and bolts and the levers that we can pull using our capabilities, but really trying to understand was the platform built in a thoughtful way or is this just something that has evolved over the last decade or so?

Peter Sullivan: Yeah. Dave, and again, it's this idea of how did we get here? And let's be honest, if we are being asked to look at an investment platform for one of our clients, whether that's an existing one or a new one, there's probably something wrong with the investment platform. It's probably missing something. And that process of looking at how did we get here, what's on the platform and your unique organization, what are those unique needs that the investment platform needs to fill. It really comes from ... I would say, Dave, in our experience it can be we have too many managers on the platform. There's too many funds, there's too many vehicles. That means essentially the research costs, the costs of doing the due diligence are probably exceeding maybe the capacity of the organization. Maybe you have one or two investment professionals or even a team of five or six that are very talented and work very hard and are really effective in doing what they do, but maybe there's not enough of them. The platform's gotten too big.

There's other times when organizations reach out to us and they recognize that the platform doesn't have enough managers. Maybe it's, and this is a common one, they're moving into an asset class that maybe they haven't trafficked in the past. Maybe they're maybe recognizing that alternatives and illiquid alternatives, which maybe have been asset classes that have been in a select few set of clients that need to be implemented across a broader subsection of the client base. And maybe they're recognizing that their lack of managers given current market conditions and our expectations for the future, there's some holes. And the final aspect of it can be they're recognizing that there's some inherent biases to their investment platform. And some of these biases may really represent some bets or some tilts that are inherent to an investment platform that is starting to show up in client performance in the form of excess tracking error, unrewarded tracking error.

And it could be as simple as, hey, the advisors, these group of advisors that our organization is built in are complaining because they're finding it challenging to talk about managers given some indications of some challenging performance. And they're finding it difficult to have those conversations with clients and implement the portfolios using the existing managers. So there's lots of different factors, and for each one of those times, we can actually ... You and I probably can talk about walking in, taking a look in a platform and just recognizing right away there's some holes or there's too many managers, a group of managers are not being used and/or they are all acting in the same way and they're either outperforming all at the same time or underperforming at the same time and that's indicating that there's a problem with diversification and there are some biases that are really there. And sometimes it's the third party, the independent third party that doesn't have any skin in the game that can highlight this.

David Pappalardo: Right. And Peter, those are some excellent points. There's a couple of things that you said that I want to amplify. One of them was you mentioned when we talk to a prospective client and they have too many investments, too many strategies on their platform. And we see this a lot and anyone who is an advisor certainly recognizes this, where a lot of times you'll have a new client that comes on board with a large portfolio and they have a number of strategies that your firm is not currently using. And you're certainly in many cases going to say, "Yes, we'll cover them. We'll start reporting on them." Because you certainly don't want to turn the client away. And you do that a number of times and all of a sudden your platform is now significantly larger in number than it was maybe by intention. So now you've got these strategies that have grown and maybe only one or two clients are using them.

I think the blind spot for a lot of firms is when we've pointed this out sometimes ... Certainly not all times, but what will happen is they'll say, "Well, that's fine because we know we have 60 strategies, but in reality, 80% of our client assets are in these 15 or these 20 strategies. It's okay. It's okay that we've got these other ones in a holding tank, so to speak." And I think the important thing to point out is that there's still risk for having those on the platform because if the client's holding them, even if it's one client, the firm needs to recognize that they have responsibility for covering that strategy. And if it's in a client portfolio, for having a due diligence file on that strategy.

And so to focus just on those 15 or 20 where most of the assets are and not pay as much attention to the other 40 names that don't have as much assets, that is a risk. It really is incumbent upon firms to shrink that list down to the point where it's all the strategies being used and they're all being treated the same way for monitoring and ongoing due diligence. And that is an area that sometimes a light bulb goes off when we talk to clients about this because it is important and you want to make sure that they have a good reason for having a strategy in a portfolio and not that, oh, that's just a one-off that the client has.

Just to shift gears, the other point that you made that I thought was important was about education. If a firm and an advisor set comes to us and wants to offer a strategy or a type of strategy that they aren't as familiar with, and that happens as you know all the time, and it certainly has been more focused on alternative investments in the last probably three to five years than really anything else. And I think it's an important point because not only does it keep happening and it will continue to keep happening, but the solution for that is it's not good enough to simply give a set of fully vetted strategies in ... Let's say private equity as one example.

If a firm comes to us and says, "We really need to get into private equity because we have clients asking about it, we know that we're perhaps at a competitive disadvantage if we're not offering it. So we need to check that box and we don't have the expertise in-house to do it, so we need your help." A big piece of that on the front end that isn't really thought about is education. Because at the end of the day, an advisor will never go to a client and make a recommendation, in our experience, without feeling comfortable about that strategy. They need to be positioned as an expert about any strategy they're talking to their client about. And if they don't feel comfortable, they will not talk to the client about it.

So it becomes incumbent on the firm and on their research partner, in this case, if we're talking about us, it'd be Segal Marco, to provide the advisors with enough information and comfort so that they can really go to the next level. So that is something that perhaps you're not dealing with on the traditional side, but in alternatives it really is a glaring example of why it's different and what needs to be done.

Peter Sullivan: It really is. And Dave, there's actually a lot to unpack there, and I think we can unpack a lot of things about investment platform design. But in private equity, generally what happens in our experience is for those firms that really have focused on the traditional asset classes, the more illiquid asset classes, they get into private equity by securing new clients. And their success introduces the asset class into the firm's sphere. Those illiquid asset classes, you can't sell them. You essentially inherit and accept them. And with private equity, what it tends to do is create another tail within the organization. So it's a tail of funds, exposures to different managers and different management styles that are not used by the rest of the firm. And these tails have meaningful impact on those clients that you've just won and worked hard to secure. But they also have a major impact on the portfolio managers and the relationship managers who all of a sudden are outside their comfort zone. They have to explain the performance and impact of these funds that are in the tails without the normal processes and support that they get from whoever's providing the research and whoever's providing the investment management support within that organization. And it has this knockdown effect on all sorts of workflows and processes and engagements within the organization.

You brought up this idea of actual concentration where you look at an investment platform, it might have 60 names on it, and you realize that when you look through to the client's actual holdings and how the advisors and portfolio managers are employing the manager platform, what you do see when you actually look at the assets and the real client exposure is you'll see a significant amount of concentration in very few managers. That happens a lot. And that is also one of the reasons why we tend to get pulled into these conversations is it may be an independent third party, which is to say at a certain point, if you have a significant portion of your firm's AUM concentrated in two or three strategies, three or four strategies, it's usually in domestic equity and quite often it's in large cap core, believe it or not. Where you have this concentrated exposure to an approach, a philosophy, and a firm and a team that underlines that fund or that strategy. What happens here is that you have client risk that is associated with that manager, which means you're actually sharing the business risk of the manager. You have an uncompensated risk to your organization and your business. Why? Because managers do go in and out of favor. We do expect a manager to have a disciplined approach.

And when that disciplined approach is out of favor and it represents a bias that's unrewarded within a broad set of clients and a high percentage of your firm, the client's investment risk starts changing and morphing into your enterprise business risk. It morphs into client risk because clients tend to get rid of their advisors and they tend to move on when specific managers underperform. And if you concentrate that risk of manager exposure, you are creating volatility and things of that matter, like revenue, client retention, bonuses and comp. It gets pretty squirrelly and it becomes a real risk that really a well constructed investment platform shouldn't introduce into any business or any organization.

David Pappalardo: Those are excellent points and ones that, again, when we talk to either new clients or prospective clients, it's those ideas that tend to be eye-openers that certainly many people in the industry recognize, but certainly not 100%. So it's always helpful to get off on the right foot to let them know it's not just a risk of a manager underperforming. There's obviously the opportunity to have a cascading impact on the practice. So in the time that we have left, I do want to touch on a few things maybe to take a step back. We've gotten into some more detail. But I think when we think about building a platform, I think for anyone listening, I think a big consideration is when we have these initial discussions are what are the asset classes that you have exposure to, and as you mentioned Peter, are there ones that you think there's a gap where there's a need that isn't filled that needs to be filled? And then a big discussion within, obviously all private wealth are the vehicles themselves.

We have some firms that we come across that love separate accounts, many that love mutual funds and quite a few others that like a combination of the two. So understanding the vehicles. And that goes to the bigger point that I mentioned I think at the beginning of our discussion, which is, what's the nature of your firm? There's certainly not a one size fits all within this business. There are lots of firms that have thousands of clients that are more modest in size where mutual funds rule a day just based on necessity and the size of the accounts. While there are a lot of others that are in the ultra-high net worth space that have many fewer clients, but the relationships themselves are very significant and they deal almost exclusively in separate accounts. And so it's really understanding that at the onset so that we know essentially what our marching orders are, what needs to be built, what needs to be evaluated so that we can figure out from our perspective. There might be gaps that the firm that is coming to us doesn't see. There's maybe a few that they've pointed out, but there's maybe others that we see that we can bring to their attention. And that's helpful.

And I think that that's a big part of the initial conversation or two to try to get some understanding and buy-in from the client. And I think another one is figuring out what the final recommended platform is going to look like. And the reason I bring that up is that in some cases a client will come to us and say, "We've got these 30 names. We've done our own internal due diligence, but we want you all to come back to us with your opinion." And sometimes they want the final platform to be a combination of the names on their existing lists that we like as an organization along with some other ideas that we think would be complimentary. But then in other cases it might just be, just evaluate the names that you see and tell us who you like and who you don't like. And again, we tend to take a very flexible approach, which is the client is going to dictate what they need and we can give our advice, but certainly it's always up to the client the best way to handle it. And what their final platform looks like has to satisfy both them and obviously be serviceable and appropriate for their clients.

Peter Sullivan: Dave, it has to be practical. Any advice our clients give to their clients has to be implemented and it has to be implemented in an effective way. And when we're consulting and making observations and making recommendations, they have to be practical and they have to be implemented. And in the intermediary world, in the ASG work that we do, changing managers, turning over managers have real costs to the clients. And having a plan from going from where the manager platform is today, which is employed by all the clients of different size and different types, different risk tolerances and different circumstances, how are you going from that platform that we have today to the one that you want to go to in the future? And it has to be practical in the fact that it has to be aware that there are transaction costs from manager turnover and changes to the manager platform.

And that turnover and those change will take time. It may take one to two or three years to get even close to the new investment manager platform. It means that to make that transition and make it practical and actually effective, it means that you really do have to incorporate what the current holdings are, what the current strategies are being employed by the majority of clients, and introducing managers that effectively need to be paired with those existing holdings. So it is a process that needs to consider the time it takes to implement it. It needs to reflect the transaction costs. It needs to reflect. The realities here is that you have to accept the existing holdings. And it also requires us to step away from this idea of picking managers and moving towards constructing portfolios. And what does that mean effectively? It's a change in mindset. You have to look at whatever new manager that is going to fit a need or fill a hole, you need to consider selecting that manager based on how it is going to be paired with an existing manager on that platform. One that you can't get rid of even if you want to over the next two to three years.

So it involves thinking about pairings, pairing a value manager with a growth manager, a taxable manager with a muni manager. It means combining managers that take different approaches to whatever asset class. Usually it's a function of quality or aggressiveness or certain biases in that approach. But you have to move away from this idea of selecting individual managers for a platform in a vacuum and holistically consider how they work in combination. And that can only be done by that look through. By focusing on what your client base looks like in aggregate.

And the last point I'll make here is you also have to consider different constituencies within the organization. So it's very easy to say for a billion dollar manager with 200 clients, whatever that average client size, you should use that average client size to dictate what vehicles and funds, the mix of separate accounts versus mutual funds and the mix of asset allocation is. It's very easy to do based on that by that AUM divided by the number of clients that you have. But in reality, when we look through the clients at the advisor level, the team level and an individual client level, it's not a very simple average there. We don't see a peak around that average $5 million client size. What we usually see are a grouping. Two centers of gravity within an organization. You'll have a group of smaller clients which have their own unique needs, their own unique requirements, and really should have their own investment platform. And then maybe on the bigger client side, maybe more sophisticated and even more demanding, you have another set of managers and another investment platform that probably should be designed for their specific needs.

And so that's where the customization goes, that's where the look through is, and that's where the conversation goes. And then that education really focuses on really what does your business look like? What type of constituencies do you have to satisfy and what final set of managers and funds on the investment platform will do the best to meet the needs of both types of clients or both constituency?

David Pappalardo: Yeah, Peter, those are great points and I think it's critically important to talk about one. Just I'll throw my two cents in. We're talking about obviously building a platform and evaluating an existing platform and arriving hopefully at a final list of recommended strategies. And I think what you point out is something that again, gets overlooked, which is coming back with a list of strategies that we think makes sense, but ultimately having that conversation with the client to say ... Let's just use one example. Say there's a manager that we love that is benchmark agnostic and shows a lot of volatility, but when paired with other managers that we like, we feel might be a good fit over the long-term for some clients. Is making sure the advisor understands that. Do they and their clients have an understanding of this type of investment behavior that they need to be patient over a certain length of market cycle? And that is not going to be the case for all advisors and all clients in all firms.

And it's important to have those conversations upfront because a big part of what we do is setting and managing expectations. Because if they hire a manager that we think makes a lot of sense and it behaves in the way that we would expect over time, but it's going to cause some strife and some anxiety for some clients and concern, at the end of the day, that's not the right manager for that firm and that client. We need to find another solution that is more in line with their expectations and temperament. And that's something again, that gets, I think, overlooked quite a bit. But that's an important point.

So we're running out of time here. We want to try to keep it about 30 minutes. The one thing that I'll mention, and again we've just scratched the surface on this topic, is once you've got the platform built, what are the ongoing needs for monitoring of the names of reporting and maintaining the platform? And again, that could be a whole other conversation that Peter and I could have, but I think it's an important thing to end on. Just that once the platform is built, that's not the end, that's the beginning for once it's implemented. And every firm is going to have different requirements, different needs on all of those points. What monitoring means to them versus our firm? Do they need us to have a conversation with them every month or every quarter or once a year? Again, it's going to vary. But getting those decisions out in the open at the beginning is critically important because we, again, want to set and manage expectations properly so that everyone is on the same page.

So again, I think this is just scratching the surface. We appreciate your time. We'll certainly be back with this topic and many others as we move forward. But thanks for listening and we really appreciate your time. Have a great day.

Peter Sullivan: Thank you.

David Pappalardo: Yeah, thanks Peter. As I said, this is-

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