Scalable Capital's Risk Based Approach to Investment

Okay, so Adam, it's a pleasure to meet you again. I attended your seminar a few days ago which was fantastic. Now, I love your approach to investing which is very much risk based and so you just look after the risk and the return looks after itself, is that right?

​I think that's very much a good way to think about it and thanks for coming and visiting us today. We've always got this belief, and I think it's a long-held belief, that risk and return are ultimately related. You know it's kind of obvious if you've got cash, very low risk, and you're ultimately not going to get a high return. If you're investing in individual stocks or even in broad market indices a lot of risk there and ultimately the long-term return is higher. But what ultimately a lot of people don't know is that over the short term that relationship breaks down because risk isn't constant. And you know the stock market is very risky over the long term and you get the return from that but over short periods you can go through periods of low risk and through periods of high risk and the return dynamics against that are very different. And it's quite complicated actually. And we are trying to take that complexity away from the clients and we're trying to manage that complexity with a big use of technology ultimately to try and give give access to a lot of people to institutional techniques of investing you know the type of investment techniques that the investment banks are providing to their institutional clients powered by their mainframe computers and put that in the hands of everyone.

Transparency of fees

​Okay so I think it's nice that you're democratizing wealth management in a way and you're doing it at a very low fee. So I think your fees are 25 basis points, so that's 0.25%, every year for the ETFs which you actually buy and sell on behalf of your clients, and 0.75% for you. So all in all it's about one percent per year which is a very reasonable fee and I think you say that the average for a wealth manager would be about 1.3% is that right?

Oh, even higher and these are just the headline numbers as well. What I think is really important to take note is that when you do invest with the traditional wealth manager there can be a lot of hidden fees. So what I like to tell our clients is there's really just one percent between the client and the assets that are ultimately driving the return they should be getting whereas when you're investing with a traditional provider it's not necessarily the case. Because you might see a headline fee of 1.5% but then underneath that is maybe a trading fee or a custody fee or an exit fee or an entry fee. So we want to try and make it simple as possible. You know the fee up front, you know what you're paying and you know exactly what you're paying for.

And it's so cool, I didn't realize because when I actually signed up, because I've signed up for your service, when you actually trade you trade on behalf of the client. So literally you can see the individual trades on your in your account generated by your algorithms.

Yeah, exactly, we show everything. We want to be as transparent as possible so when you log into the cockpit you can see every single trade, you can see the prices that we paid, we can see the changes that are going on. You click on another screen you can see to the pounds and pence what type of fees you've been paying us. That level of transparency you don't get with the traditional industry.

And honesty too, because it's often, you know, slightly misleading if you don't know what fees you're paying.

Yeah, completely, and so when people log into our platform there's actually not a lot they can do. They can see everything, but all they can really do is add more money, take money out, and change their risk category if they would like to, although we don't recommend it because it's typically bad behavior if they're doing such things. But everything else is just a read only, you know, window into everything that we're doing on their behalf.

200 million euros in assets under management

Now I see that you've just crossed the 200 million euro threshold, you just tweeted it, yeah, and you're gaining money at an alarming rate so how's that going?

Yeah we're really excited. So we crossed a hundred million euros in December of last year and now it's the last day of March of 2017, we just crossed 200 million euros so the rate of growth at the moment has been accelerating and it's been a function of us becoming more well known but also a function of people adding more money into their accounts. And so when we look at the clients who joined us a year ago they've more than doubled their initial investments and they're also telling their friends about it. And this is exactly what we wanted to do when we started the business a little over a ago when we started managing client money. We wanted to provide regular people with quality access to long-term investment propositions and they really didn't have access to that before.

Making a service our mums could use

So tell me about your mother. Because I think one of the lovely things you said in the seminar was that you wanted to create something that you could sell to your family.

Yeah, of course, so my background, a similar background to yourself working for an investment bank within a trading role and because of that friends and family would always ask me "what should I do with my money?". You know I'm the expert, apparently. And I honestly didn't have anywhere good to send them. I felt like I could send them to a DIY house, and if I was do that it would be very much be a kind of buyer beware proposition for them, and I didn't know, I didn't feel like they knew enough to be able to do that, and they couldn't access wealth managers, IFAs, because they didn't have the several hundreds of thousands that you need to get access to an IFA. Not necessarily needed one either, because they had quite a simple financial position, you know maybe they need to use their ISA, they need to stay invested for the long term but they don't have a complex tax situation to deal. Yeah. So I was trying to create that service for everyone so that you didn't have to send them to a DIY proposition. You know we like to say that you know we created a service that even our mums use, you know, and that's the service we wanted to create. Something that I'm happy to provide a service to people that I trust the most and they trust me the most and if you have that philosophy at your heart the I think you're always going to be moving in the right direction.

Scalable provides a service not a fund

Okay, so in the video I did of my onboarding I used the word "robo fund". Now you don't like that so you'll see in the actual blog I've changed it to "robo investment". So perhaps you'd like to explain the difference between the two and why that nuanced definition matters.

Sure, so I don't like the word "fund" because a fund is ultimately a financial product. But we're not selling a product here we're really selling a service. And a fund is basically makes it feel like you, and every other client, are in the same vehicle. You're being treated in exactly the same way.

Tuning risk for individual client portfolios

So maybe it's good to explain how a fund works. So you have hundreds, thousands of people that pool their capital together then there's a fund manager and they buy and sell assets on their behalf and everybody gains or loses the same amount according to the value of those assets.

Exactly, exactly. And the way that we manage money is slightly different but well the main difference is that every every client has their money managed individually. So there's no actual fund vehicle around the whole thing. So you and I could be in the same risk category in our service, so we could be in our medium risk category, which we define slightly differently, and I don't want to go into the detail in this answer. And we could have joined on different days and therefore might have slightly different portfolios because we're going to make sure that the mix of assets you have is exactly the right mix of assets for the day that you joined and that you don't move into my portfolio and pay extra costs when you don't need to.

So by treating clients as individuals it allows you to make sure that they always have the best best mix but it also gives you so much more flexibility going forward. You know by providing a personalized service you could think about, you know, all of a sudden taking things into account like tax, maximizing ISA allowances, making use of your pension. All of this stuff wouldn't be possible if you just had a fund. So that's I think what you see today when you use a robo investor, and I don't like the term "robo" either, the reason I don't like "robo" is because I feel like it's dumbing down what we're doing.

You know we're using technology to really create a more sophisticated offering for your average investor. And "robo" makes it sound like it's actually not that sophisticated. But if you think about where we are now and what we offer now and what's going to be offered five years from now or ten years from now the future looks very interesting in terms of being able to provide contextual, intelligent communications, being able to nudge our clients in the right way so they behave in a very behave well in terms of their long-term investment goals... You couldn't do that five or ten years ago. You can't do it yet in the way that we want to do it but with advances in computational power in things like machine learning and artificial intelligence there's a lot of interesting things that we could do down the line.

That's really fascinating. So each of the clients you have is is treated differently, and the way you approach things is also very different from other from other robo investing platforms. Okay I had to think about that. So let's just think about what's going to happen if your fund goes wrong. So your approach is to say, okay, well volatility, which is how much markets fluctuate on a daily or weekly or a monthly basis, that's sticky. So when volatility's high it usually stays high, when vol's low it stays low, we have these regimes which last a long time. So although you can't forecast returns you can forecast volatility fairly well.

Exactly.

And you make use of that in your modelling.

Yeah that's exactly right. So what we do is we know that everybody has an individual risk tolerance. You know I might be able to stomach a thirty percent loss and you might only be able to stomach a ten percent loss in your portfolio before you get very nervous and you pull all of your money out. And what we know is that when people do that they stay out for too long. They stay out for months, for years even, and by doing that they actually underperform because they protect themselves from some of the fall but they also miss out on a lot of the rebound. So by taking this observation that we have which is that when risk changes, when volatility increases, we know that in the future it's going to remain higher, we can take action. So we run a lot of simulations on asset classes and look at that look at this risk and whenever we see that risk is going up we make adjustments to the clients' portfolios to keep in line with their individual risk tolerance. So when you say "look I actually can't stomach a loss of more than ten percent" we make sure that we're making adjustments to your portfolio so that the assets that we have in most of the cases, or what we would call kind of in the good scenarios and the average scenarios, not in a bad year, never breached that risk tolerance. We never guarantee anything because ultimately everything can go to zero in in the publicly traded markets. But we do have an indication of, in the best ninety-five percent of cases, or in the worst five percent of cases, what type of loss might be typical and then we manage to that. So if you say "look, I'm happy to experience a loss of that magnitude in one in every 20 years, so in a very bad year, then we can manage to that risk and we can make adjustments to make sure you have the best asset mix so you can stay invested and ultimately get that long-term return that you deserve.

Terminator vs Teletubby marketing

I was amazed because when I actually signed up for it you mentioned "Value at Risk". Now this is something I had to deal with for a long time when I was working as a quant in risk management but I think that must be very difficult to explain to your clients. So you know if I were to compare your marketing with something like Nutmeg they've got much more of a kind of Tellytubby approach whereas you're a bit more like Terminator, I'd say. A bit more scary but potentially...

So everybody always mentions Terminator because I think that he's kind of the the evil robot that everybody feels like, you know, the machines and the automation that we're going through now is trying to this..

But Arnie was actually a nice guy right?

He was, but I grew up with Short Circuit right? You know the friendliest robot you could imagine so this is the world that I live in. But yeah, Value at Risk it's an institutional risk measurements you know it's used at the central bank's, it's used at the banks. It has been used incorrectly. So the way, when people hear Value at Risk they sometimes think "yeah, but didn't that cause the Financial Crisis?". The thing is the Value at Risk didn't cause the financial crisis, the way that people abused the measurement of Value at Risk was obviously one of the reasons why people underestimated the amount of risk in their portfolios and thus took a larger magnitude of losses than than they thought they would.

Measuring Risk Appetite with Value at Risk (VaR)

But the concept behind Value at Risk is a very simple one isn't it? When you buy any asset, or a portfolio of assets, you get this distribution of daily returns so most of the time it's roughly zero sometimes it's very high, very low and generally it drifts upwards so it's slightly positive and that's what you're trying to to kind of squeeze out of your portfolios. And then this Value at Risk just looks at the bottom tail, that bottom five percent of risk. So you're saying every ten years I'm willing to lose, say, x percent of my portfolio, that's my risk tolerance.

Yeah, exactly. And how you then build that distribution how you model you know the potential outcomes that's where you need to make sure you're making the right assumptions.

Simulating the Future by Monte Carlo Sampling

And now you use Monte Carlo sampling as well so let's try and explain that. Yeah. While we're at it. We talked about VaR, why not, let's just go for it.

​Yeah, of course, let's get into the detail.

So I'm a physicist so the way I always think of things in terms of quantum mechanics. I'm not so I don't so let's see where we go with this.

Let's say I was to throw you something, right? So I take my keys and I throw this to you, it would actually follow something like a parabola. Yeah. Because that's the Path of Least Action they call it in Physics. So if we look at quantum mechanics it would actually follow all possible paths but the most likely path will be the one that it would followed on the macroscopic scale scale. So in Monte Carlo sampling what you're doing is looking at all possible futures. You're simulating thousands of possible futures. It'll cluster around the most likely path of the future but you also consider even the unlikely possible futures for every asset type. Is that the way you approach it?

Yeah, so we build let's let's say for example 10,000 different possible paths for each asset class that we invest into. So when we look at the future possibilities for each asset class you have basically tens of thousands of lives basically going...

The wiggly lines, I remember that well.

Most of them are in the middle but you're right a few of them are on the edges as well, they're the outliers, they're the ones which could happen with very low probability with a very good outcome but also very low probability with a bad outcome. And obviously it's those bad outcomes that we care the most about because they're the ones where people get nervous. So then you take those 10,000 paths and you look at the worst 500 of them and then you draw a line in the sand and you say you know "what level were 500 of those paths worse than and the other 9,500 better than?". And you can mark that line and you say "okay that is a twenty percent value at risk portfolio" because 500 of the paths were lower than that level and 9,500 were higher. And that's the basis of how we then do our risk modelling and our risk management.

Academic study from Yale shows managing risk gives good returns

And then the magical thing is if you actually back test these kind of approaches where you're just kind of going for the portfolios which avoid those bad outcomes, magically it gives you good returns over the long term, is that right? You were talking about a study that was recently done...

Yeah there was a study which came out of Yale University which looked at controlling this volatility versus a buy-and-hold strategy, so a passive investment strategy which is very popular and is better than most of the strategies if you have to try and follow an actively managed approach. And what they saw was that by controlling for this downside risk because risk is predictable you actually saw better risk-adjusted returns. So you saw for the fluctuations that were happening in the portfolio you are actually outperforming the buy-and-hold strategy. And they conducted this study in 19 different OECD markets and they saw that it was it was relevant everywhere they looked. And it's because firstly risk is predictable but secondly when risk gets higher than normal or lower than normal you actually don't get the return you deserve in higher than normal periods you get punished for that risk. You know it's the same the good example is the Financial Crisis. Yes. You know in the Financial Crisis risk went up but you weren't rewarded for that risk you were heavily punished. And this happens time and time again. So if you use this predictability of risk to get out of the markets during these times where risk is inflated and get back into them when risk is lower than usual you can take advantage of that feature this volatility clustering effect in the market to build a portfolio which potentially will outperform but more importantly always in line with your risk tolerance. Yeah. So even if it didn't outperform hopefully you can stay invested for longer whereas in the other one you may have actually got out because it was too volatile for your own personal risk tolerance and if you get out you don't get the return.

What could go wrong? Blue sky turbulence...

Okay, that's a nice way of explaining it. I think I'll finish by asking one last question about what could possibly go wrong. So it's a difficult question I guess. So if you are managing for risk and you do depend on this kind of volatility clustering, the kind of thing that could go wrong is when you don't have a warning from volatility right? So this is like blue sky turbulence: you're in your aeroplane, it's a sunny day, everything's fine and then suddenly your aeroplane drops 10,000 feet. I mean it could be a cometary strike on New York or things that you couldn't foresee. Now nobody can really manage for that, but how would you step into the machine if there is such a crisis? And I think you've done that recently when we saw this very big fall in sterling.

Sure so yeah I think that you put it very well, what are the alternatives? If something as drastic as a comet strike on New York was to happen obviously markets, everything everything would perform very very badly and it would happen instantaneously. And you see this with natural disasters, you see it with terrorist attacks and what you typically see after those events is that the markets rebound. You don't get any volatility going into the event because nobody knows it's going to happen but what you see is they usually recover fairly quickly. You know after nine eleven we saw exactly the same thing there that's been one of the worst terrorist attacks on the Western world and the markets rebound fairly quickly.

With business cycle volatility you do see tremors occurring before the big events. So the Financial Crisis didn't start with Lehman Brothers. It started over a year earlier with institutions like Bear Stearns and some of the hedge funds that they were managing and some of the mortgage companies in the US. The volatility started way in advance of when the crashed really started to occur and as such it means that that volatility can be managed and can be controlled and actions can be taken going into that using using a data-driven approach.

The sterling case falls a little bit more into that bucket because on the day of the EU Referendum result, which was unexpected, it wasn't as if sterling hadn't moved for three weeks. The volatility in sterling itself had already started to pick up so going into that event we started to reallocate away from some of the asset classes that we started to see more volatility in, so things like EU and UK stocks we started to move away and we started going to US stocks because it looked less volatile and on the day of the Referendum itself after the result the only negatively performing asset in GBP was EU stocks. US stocks were up on the day because they were priced in pounds and the pound was so low, so by making those switches we actually had a very very good experience.

So as long as we get some type of control or tremors or indication that risk is increasing going into events we will be making changes. And versus the alternatives, which means just keeping things static and hoping everything works out for the best, or moving into cash and getting super nervous I much prefer our strategy as a way of dynamically using the data that we have right now to make the best changes we possibly can in the portfolio but in an unemotional way. Because emotions are one of the worst things you can have when you're when you're trying to deal with the capital markets.

And one of the worst enemies of an investor.

Totally, totally.

Anyway, thank you very much for your time it's been a real pleasure.

Great! Thank you for having me.

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