Are there any investment “truths” that haven’t been shattered during the past 18 months? Diversification that was meant to smooth returns in difficult markets failed to deliver, even for wealthy investors with highly complex, multi-asset-class portfolios. Many hedge funds didn’t provide a hedge. Even supposedly “safe” investments like municipal bonds have taken investors for a wild ride.
The depth and breadth of this market crisis have called the very foundations of modern portfolio theory into question just when they were needed the most.
This state of affairs poses a dilemma for wealth managers, who, for a generation, have adhered to the core principles of asset allocation and earned their keep by preaching the mantras of “buy and hold,” “invest for the long term,” and when things get tough, “stay the course.”
On the face of it, sticking with an investment strategy across market cycles should have inherent appeal for ultra-wealthy families, who tend to have multigenerational time horizons and can afford to take the long view.
But with dramatic losses shocking the system, simply raising cash or moving to the low end of target ranges for risky assets can sometimes feel like rearranging deck chairs on the Titanic.
“I noticed that most advisers have been chanting the same mantra today as they did last year when the market was much higher,” said one participant in a recent online discussion among members of the Institute for Private Investors, a peer networking and educational organization for ultra-wealthy families. “When I listen to them today, I don’t know if I can trust their advice when they were so wrong last year. In fact, I’m finding it hard to trust anyone in the business anymore.”
Another investor says: “[Those advisers] sound like a broken record. They need to actually think and change their tune so that I actually believe they know what they are doing before I invest with them.”
Investors have also begun reassessing the value of hedge funds, especially those that promised “absolute returns.”
Last autumn, three-quarters of IPI members who were surveyed reported that “few” to “none” of their absolute return managers were producing positive returns amidst the market turmoil. And in 2008, when the average hedge fund lost nearly a fifth of its value, hedge funds did not cushion the downside. According to IPI’s annual Family Performance Tracking® survey, investors with more than a quarter of their portfolios allocated to hedge funds underperformed respondents’ average return of –18.84 per cent, and those with less than 25 per cent in hedge funds outperformed the average.
As one IPI member put it in a recent online discussion: “Absolute return is a marketer’s dream because it suggests you can get steady returns without taking on any risk.”
With so many tried and true precepts crumbling under the weight of this downturn, where do investors go from here? The urge to “do something” can be powerful but the consequences just as disappointing. Consider the case of an investor who makes a poorly timed shift in allocations — against the advice of his or her adviser — only to watch the new holdings drop in value. The investor regrets the decision and may well blame the adviser for failing to prevent the move, putting the overall relationship in jeopardy.
Unfortunately, even a carefully crafted investment policy statement isn’t necessarily equipped to guide investors through a crisis. “To simply say that one has some mix of stocks, bonds, cash, etc. and a long-term view seems insufficient,” one IPI investor recently told his peers during an online discussion of the merits of a formal investment policy. “Imagine you are in Poland in 1939 and have a foreign relations policy of neutrality and nonalignment. Then Germany invades . . . So much for policy.”
Many investors would benefit from a broader framework. “Some sort of written statement of approach to wealth management is needed that is more encompassing than simply investment policy,” this investor declared. Although an exhaustive list of the relevant considerations “could fill a book or two,” the investor added, they should include factors such as the relative importance of “growth” versus “safety,” life-cycle needs, a spending rule, tax management, the impact of inflation on spending power, manager selection criteria, scenario analysis, and crisis management.
Several new approaches seek to address the shortcomings of the standard framework by focusing investors’ attention on better understanding the risks they are (or are not) willing to bear so that they can make better decisions.
Ashvin Chhabra, chief investment officer of the Institute for Advanced Study in Princeton, New Jersey, and a former managing director in the global wealth management division of Merrill Lynch, says that the standard definition of risk as volatility is woefully inadequate.
He suggests that investors would be better positioned to manage risk by dividing their portfolios into three parts: “personal risk” that emphasizes safety and provides for a standard of living, “market risk” that delivers market-level returns, and “aspirational risk” where investors can feel freer to take significant risk to potentially enhance returns and grow their wealth.
Of course, the tricky thing about risk is that it manifests itself in unexpected ways. In this environment, any candid conversation between investors and advisers must not only cover the pros and cons of “staying the course” but also include a frank discussion of whether the adviser dispensing advice will stay employed and his firm will stay in business. One unfortunate consequence of this crisis is that many wealth managers are cutting costs and trimming senior staff at time when the wisdom of seasoned professionals is needed most.
— Len Costa, Institute for Private Investors
Editor’s note: This article was originally published in the Financial Times FTfm supplement on 6 April 2009 and is reprinted here with permission. |
