Wealth managers taking a leaf out of the institutional book

For most investors, the 2000s were a ‘lost decade’ – risk failed to generate return. But it did not end there. Of the 20 biggest daily upswings in the S&P 500 since 1980, 10 have occurred in the past four years. Likewise, of the 20 biggest downswings, 13 have taken place in the past four years.

Accordingly, institutional investors worldwide have been developing new approaches to asset allocation and their modified versions are also being implemented by wealth managers.

In the 1990s, defined benefit (DB) plans typically had the 60/40 equity/bond mix. This position inflicted big deficits during the equity bear market of 2000 to 2002. Plans duly diversified into alternatives that aimed to offer uncorrelated absolute returns, but most proved highly correlated with equities in the 2008 credit crunch, forcing a deep introspection. Since then, strands of the new approach have been coming into view, according to the Citi/Create research progamme.

First, DB plans are adopting a twin-track approach that blends short-term opportunism with buy-and-hold investing.

Second, diversification is staging a reincarnation, with broad palates of lowly correlated assets targeting multiple goals such as capital growth, regular income, stable cash flow, high liquidity and inflation protection. A clear distinction is made between alpha and beta returns.

Third, pension plans are adopting an eclectic approach to risk. Some are ramping up the risk to venture further out on the risk curve in search of higher yielding assets. Others are adopting liability driven investing to hedge out the unrewarded risks.

Room to manoeuvre

Parallel strands are evident in the approaches now being adopted by wealth managers. These focus on their clients’ goals with respect to basic day-to-day necessities, lifestyle needs, philanthropic aspirations and estate planning.

A blend of assets is increasingly used in the process. Private clients are seeking capital growth, regular income, high liquidity, inflation protection, low volatility and catastrophe avoidance. The resulting portfolios retain their long-term orientation, while being nimble enough to take advantage of bargains in the marketplace.

One approach centres on the core-satellite model. Buy-and-hold investing is concentrated at the core and opportunism at the satellites. Such pragmatism puts heavy emphasis on risk, liquidity and transparency.

There are three other respects in which wealth managers are running in tandem with their institutional peers. First, their asset allocation choices are no longer influenced by the pattern of average returns over time. Instead, they seek to predict mean reversion at various points in the market cycle. The latter provides a better guide to future risk premia.

Second, the evolving diversification no longer tracks relative returns benchmarks. In most cases, it seeks absolute returns that focus on risk minimisation more than return maximisation.

Third, wealth managers now draw a clear distinction between re-risking and smart risking: one involves dialing up risk; the other involves the investor’s equivalent of the Holy Grail – getting additional alpha without taking on further beta risks. It relies on market indices and a more diverse asset base to create ‘smart beta’ that delivers cheap alpha.

Historically, risk was measured as the probability of a given loss or the amount that can be lost with a given probability at the end of a defined investment horizon. This measure only considered the final result. However, since the bear market of 2000-02, investors have been hit by waves of losses within their investment horizons.

Many good investment products have not survived the resulting panic selling. ‘Wrong time’ risk has emerged like a bolt from the blue, only to be superseded by ‘regret’ risk when markets recovered sharply. By amplifying investor mood swings, the 24-hour news cycle has conspired against value investing as well as time premium.

The special relationship

Investors know they need to be nimble and adjust their weightings to reflect changing valuations. But they also know dynamic investing can be very risky. It requires a high degree of engagement between wealth managers and their clients. In fact, investors may need to delegate some discretion so that their advisers can act quickly to capitalise on fleeting dislocations. But when the dislocation is more persistent, they must have a willingness to appear wrong for an extended period of time until markets normalise.

Hence the role of a ‘Trusted Adviser’ has gained traction in the wealth management sector. It seeks to minimise herd instinct and deliver better outcomes.

These new approaches are in their formative phase. It is hard to tell whether they will fare better than the ones they are replacing. But one thing is clear: the search for better ways of investing has intensified in all investor segments. Institutional quality tools are no longer the preserve of the institutional segment.

Amin Rajan is CEO of CREATE-Research