What are the ‘financial engines’?
A closer look at our backstory.
Article published: June 21, 2023
You are the engine of your wealth. You’ve worked hard, saved as much as you can, and built a strategy to reach your goals. Just as you’ve powered your way to where you are today, our “financial engines” are the investment portfolios that power your integrated wealth. To be more specific, they’re the algorithms that underpin the construction of our portfolios. Let’s look at the company’s origins and see how those engines work to deliver personalized, tax-smart investment strategies.
The origins
Financial Engines (later renamed ѨƵ after a merger with Edelman Financial Services) was co-founded in 1996 by Dr. William F. Sharpe, a recipient of the 1990 Nobel Memorial Prize in Economic Sciences for his pioneering work on the theory of financial economics. Dr. Sharpe teamed up with a group of experts in finance, economics and mathematics to build a new “engine” – a disciplined approach to investing for individuals.
The goal was to apply the best practices from academic finance and institutional investing to the needs of individual investors, no matter what their financial balances were.
At the time, there were two things happening in the investment landscape. The first was the shift from Defined Benefit plans (pensions) to Defined Contribution plans (401(k)s), which left the burden of investment decisions on the individual. The second was the rise of the internet, particularly in the heart of Silicon Valley, home to Financial Engines and Stanford University, the alma mater of many starting members.
Christopher Jones, former chief investment officer and now a senior advisor to ѨƵ, was one of the company’s first employees, building and managing the team of investing experts from the ground up. As he recalls, “Dr. Sharpe saw the opportunity for bringing both of these seismic shifts together, by combining powerful software technologies with sophisticated financial theory, which would ultimately serve individuals – regardless of their wealth or investment expertise – to provide independent, objective investment advice.”
What goes in the engines?
The first problem the team faced when building the “financial engine” was how to model a wide range of scenarios about how the economy and financial markets might evolve over time to give people a realistic view of possible future outcomes. They would rely on Dr. Sharpe’s pioneering work in financial economics, including how prices of financial assets are determined, and the link between risk and return.
To solve this, the “engine” uses what the team called the “Pricing Kernel” – a model that takes current economic conditions like inflation and interest rates and generates thousands of possible future paths for how the stock and bond markets might perform in the future. The goal was to identify possible paths that reflect how markets actually behave: How do inflation and interest rates interact? How do different asset classes move with each other? How do unexpected economic shocks play out over time?
Next, the team worked to show how a range of different asset classes might behave in each of these future scenarios. The framework divides the investing world into 16 different asset classes, each with their own behavior and patterns of performance. Each future scenario considers how each of the asset classes might perform in relation to each other under an array of possible circumstances.
From there, Financial Engines built models to capture the characteristics of more than 38,000 mutual funds, Exchange-Traded Funds and individual stocks, each incorporating a mix of exposures to up to 16 different asset classes, along with a host of characteristics that might cause their behavior to differ from the broad asset classes. This includes risk factors that might be specific to that fund or company, the impact of fees and expenses, capturing the impact of taxes, and modeling the predictable components of active manager performance. With this sophisticated security-specific forecasting tool, investors can see the full range of possible outcomes for their particular investments.
Next, the team developed the ability to analyze thousands of possible securities to build customized investment strategies, taking into consideration an individual’s time horizon, goals, preferences for risk, and even their tax situation.
What makes the engines different?
The end result is a sophisticated investment engine, backed by empirical data and academic rigor, that allows for personalized, tax-smart investment strategies designed to meet the needs, goals and risk tolerance of our clients.
“The ‘engines’ give us the ability to apply a time-tested, disciplined approach based on the best practices from modern financial economics to the investing needs for each of our clients. We can structure investment mixes and offer personalized advice across different tax scenarios and retirement goals,” says Chris Jones, “as well as provide regular rebalancing to help prevent asset allocation drifting past its parameters. We believe our approach is unprecedented and unique in the business.”
Investing strategies, such as asset allocation, diversification or rebalancing, do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. All investments have inherent risks, including loss of principal. There are no guarantees that a portfolio employing these or any other strategy will outperform a portfolio that does not engage in such strategies.
Past performance does not guarantee future results.
AM3698687
