A refreshing outlook on risk

It is indisputable that getting the appropriate long-term asset allocation is a fundamental cornerstone of the investment process. But strategic allocation alone is not sufficient to reach clients’ objectives, said Patrizio Merciai, head of private investors at Merrill Lynch Bank in Switzerland, addressing an audience of 130 leading Continental European wealth managers at the Financial Times Business private banking summit in Geneva in November.

In the past few decades, asset allocation in private banks has been conceived and developed principally to provide portfolio diversification. But many fortunes, recent and less so, have been generated by taking substantial risk and not through diversification, said Mr Merciai, bringing a refreshing point of view to private banking strategy.

A survey carried out by Forbes on the principal sources of wealth generation was the starting point for developing the framework for long-term asset allocation at Merrill Lynch. In-house analysis shows that 73 per cent of Forbes’ top 400 rich list in 2005 have become wealthy by owning or developing a business and 14 per cent by making investments in the alternatives space, hedge funds and private equity. Seven per cent have become prosperous thanks to inheritance or marriage, “which also can be defined as a concentrated risk.” For 6 per cent of the rich list, real estate was the main money-maker.

But diversification on one side and the fact that wealth creation is made and will continue to be made through substantial risk of capital are two conflicting objectives, said Mr Merciai.

‘A simple and powerful way of meeting clients’ needs with tailored solutions is to adopt a strategic core and tactical peripheral approach, at the same time splitting the portfolio in capital protection, market and aspirational segments’ - Patrizio Merciai, Merrill Lynch

At Merrill Lynch, the solution to this internal contradiction has been to “develop a holistic approach to wealth management.”

Clients’ risk exposure can be structured in three compartments: personal risk, market risk and aspirational risk, each with a distinct goal setting. The objective of personal risk, which is symbolised by the investor’s own property, is not to jeopardise the basic standard of living, which leads investors to be willing to accept below market returns for reduced risk.

The aim of market risk, according to Mr Merciai, is to maintain lifestyle to attain market level performance from a broadly diversified portfolio.

“But then each investor has also to take some aspirational risk, to take some concentrated bets to move their lifestyles to the next step, to get richer,” said Mr Merciai. “If the framework may look simple, challenges will come when you start to populate it,” he said. “A simple and powerful way of meeting clients’ needs with tailored solutions is to adopt a strategic core and tactical peripheral approach, at the same time splitting the portfolio in capital protection, market and aspirational segments.”

If tactical overlays or other kinds of active management are necessary to generate extra cash return, scalability can become an issue in the development of such an approach.

“To try to reach scalability, to try to share investment solutions with a wider range of clients, we have developed certain dedicated segments which can be re-used as overlays,” said Mr Merciai.

One of these overlays is a “shopping list for M&A targets balanced with defensive portfolios investing in lagging sectors.”

The other major development in asset allocation has been the repositioning of so-called alternative investments to become integral part of an investor’s portfolio. While investments such as hedge funds, property or real estate enable to move further out the risk-return efficiency frontier, they carry with them a big premium in selection and access to market and manager skills, said Mr Merciai. “If we want to consider alternative investments as an integral part of portfolios, it also means that we want to have a balance between investments that are mostly exposed to market dimensions and investments that rely very much on specific or personal manager skills.”

All those different dimensions – core and tactical, diversification between traditional alternative investments, between market exposure and individual manager skills – are placed into the three compartments identified in personal, market and aspirational risk, explained Mr Merciai.

“All those different pieces of the puzzle are then reintegrated in that holistic framework.”

The value of new tactical techniques was expressed by other firms participating at the private banking summit.

Arun Ratra, chief investment officer at the asset management division at Credit Suisse demonstrated another example of how the traditional approach to wealth management is being refreshed. He explains that in the last 14-15 months his bank has brought tactical asset allocation previously pioneered in the institutional sphere to the private banking world. “We combine the output of our two global tactical asset allocation models with a number of quantitative indicators and score cards, which offer a sensibility check on whether the quantitative asset allocation makes sense or not.”

But a big emphasis is placed on the “communicability” to the client. “The input from our quantitative model goes to our global investment committee, which meets weekly, and then it is communicated in a very simple manner to our clients. It is important to have these sophisticated techniques but it is equally important to get the message across,” said Mr Ratra.

Academic thinking vs practice

The other truth emerging in the asset allocation space is that there is a discrepancy between academic teaching and the way portfolio structuring is implemented in practice. If in the most prestigious business schools allocation is still in many cases seen as an optimal split between equity and bonds, most of the major institutions have moved to a thematic approach for private clients.

Credit Suisse, for example, has drawn up a whole list of structural investment themes “that clients can understand and relate to in their personal life,” explained Maria Lamas, Zurich-based head of products at the Swiss bank. The advisability of re-rating emerging markets such as Korea or Taiwan, the necessity for huge infrastructure in both emerging and developed countries, the need to invest in natural resources and renewable sources of energy, the expansion of the healthcare industry to meet the needs of people in their quest for a longer life or simply in their improbable hunt for an eternal youth, and the attractiveness of Bric (Brazil, Russia, India, China) countries were among themes listed by Ms Lamas at the private banking summit.

“Themes come mainly from our clients,” said Ms Lamas “and then we translate them into products.” And there is no shade of doubt that there will be always products out there to cover these themes. In order to ensure this, Credit Suisse strikes relationships with firms in the relevant field, such as the current one with GE, to build a fund addressing the infrastructure theme.

The minimum amount of investment that Credit Suisse sets in order to structure a new product is $3m or equally e3m, confided Ms Lamas. “But being a global company, we are always able to find a number of clients who have got the same idea, this way addressing the issue of scalability.”

What is clear is that moving from the equity, bond and cash allocation to a multi-asset model has already generated some difficulties from the theoretical or academic point of view. “The problem is that the correlation of returns between these new assets is very unstable, we don’t know how they are going to perform relatively to each other,” explained Guy Monson, group chief investment officer at the Basle-based Sarasin Group.

‘If you just go to the village shop you don’t have to take the Rolls Royce, you can take the Renault. So you don’t always need to buy a top of the range multi-manager distributed fund, with perhaps two layers of fees. You can buy the iShare solution’ - Guy Monson, Sarasin Group

Multi-asset vs multi-manager

The truth is that there is a very short history available showing the behaviour of some of these asset classes, unlike the US or UK market, where there are 50 years of very clean data, said Mr Monson. At best, there are 10 to 12 years of performance records in the hedge fund industry and much less in the private equity industry. “But one should think ahead too and find how to work long-term themes in a risk-adjusted manner into client portfolios. But there the academic underpinning is very thin.”

But does multi-asset allocation necessarily mean a multi-manager approach?

This drive to find “best of breed managers” has been very successful, enabling investors to access many styles. But Mr Monson questioned whether going forward the additional value delivered by multi-manager strategies “are worth the total expense ratio.”

“While in 2005, when equity market breadth was at record levels, a boutique manager who had bought mid caps and a range of small caps and stayed away from the index naturally outperformed, the trend now is going into reverse,” he estimated. “Multi-manager strategies are going to find it a lot more difficult when the super caps are performing, whether they can necessarily add value.”

Indeed, there is also huge competition coming from the ETF market, which makes asset allocation across a wide range of asset classes instantly available, said Mr Monson. “When we are running our asset allocation model, spending the clients’ total expense ratio is a big thing to us. If you just go to the village shop you don’t have to take the Rolls Royce, you can take the Renault,” he argued. “So you don’t always need to buy a top of the range multi-manager distributed fund, with perhaps two layers of fees. You can buy the iShare solution.”

But while many companies continue to outsource to multi-manager specialists, others have brought back in-house this business. For example Schroders, who previously employed Russell Investment Group to select managers, has now internalised this business and has set up a consistent multi-manager business for other firms too. Rupert Robinson, head of investment at Schroders private bank in London warned that “most private investors have unrealistic expectations that adopting a multi-manager approach will deliver superior returns.”

‘Most private investors have unrealistic expectations that adopting a multi-manager approach will deliver superior returns’ - Rupert Robinson, Schroders

Consultant driven multi-manager funds or models and managed accounts, he said, are often subject to fashion, so that investors end up buying yesterday’s winners rather than tomorrow’s winners.

Mr Monson highlighted the importance of adopting an open architecture that pays dividends for investors. In particular, identifying external management talent is key in the alternative space, where the manager risk is the single largest risk, he said. “If you go into private equity, unless you pick top quartile manager you under-perform, in fact you don’t even generate any return.”

On the contrary, in certain regions and markets it is easier to outperform the benchmark. “History has shown that US large caps equities has been an area of disappointment for active management, while in US small caps or emerging markets active management has proved it can add value.”

But bringing back the manager selection task back in-house has not stopped the process towards open architecture at Schroders. On the contrary, while five years ago, the discretionary element of the private banking portfolio had more than 90 per cent invested in in-house or group related products, today at least 50 per cent of investors’ portfolios are invested in external investment vehicles, including traditional and alternative asset classes. It seems nowadays that fund houses are competing with each other in stating how open their architecture is.

Mr Merciai at Merrill Lynch states the bank is one of the most open in the industry, employing 400 external firms in their due diligence universe and has appointed 50/60 managers on a sub-advisory basis. He said that seventy per cent of his bank’s total private investors’ portfolios is invested in third-party products, even for smaller clients. “Some investors want to have exclusively third-party managers, so that their portfolio will be 100 per cent open.”

The FT Business Private Banking Summit was held in Geneva on 7 November. Speakers were invited by Professional Wealth Management, the event was also supported by The Banker and sponsored by BNP Paribas and Barclays Capital. To download speaker presentations and to review information about further events, please visit the website: www.ftbusinessevents.com