Investment Landscape

In a highly competitive marketplace, investment advisers need to be receptive to incorporating new investment ideas into client portfolios. Ideas that now represent the standard tenets of current portfolio management — modern portfolio theory, behavioral finance, Monte Carlo simulation, option pricing theory, the efficient market hypothesis, and asset allocation — took 20–40 years to be widely accepted in the investment community. Today, ideas in the investment industry that seem to be on the fringe will be in client portfolios within the next two to three years. Wealth managers need to be paying attention to those ideas now.

Objectives-Based Portfolios. The institutional model has certain characteristics — such as a long-term investment horizon, discipline to an agreed-upon investment policy statement, decisions driven by asset/liability matching objectives, and in the United States, tax exemption — that do not consistently apply to individuals. Rather, individuals tend to be “objectives based,” that is, driven (in varying degrees) by three common objectives: (1) maintain or improve lifestyle, (2) transfer wealth to heirs or charity, and (3) pay as little in taxes as possible.

Also, individuals frequently make seemingly “irrational” decisions with respect to their money. For example, many people have money in a savings account earning a low interest rate while maintaining outstanding credit card debt costing them much more. Because money is fungible, this is an economically irrational decision, but not to people who have mentally “bucketed” different pools of money for different purposes.

How might this bucketing translate into portfolio construction for an individual? Consider Figure 1 , which shows four objectives-based categories or subportfolios that represent a way in which ultra affluent clients might think about their money. How should one optimize such a “bucketed” overall portfolio? One way might be to optimize each subportfolio and then “roll up” the subportfolios to achieve overall optimization.

In contrast, I suggest optimizing the overall portfolio and then using the identified subportfolios primarily for presentation and explanation purposes (i.e., not worry about whether each subportfolio is “optimized” because each bucket is primarily psychologically, not quantitatively, driven). For example, although the overall portfolio might be optimized, the client could be presented with objective-specific subportfolios that represent the way the client actually thinks about his or her money — perhaps (1) the “stay-rich” bucket (i.e., capital preservation and inflation protection), (2) the market exposure or beta bucket, (3) the diversifier bucket, and (4) the “get-richer” bucket. Each of these subportfolios has a very different mandate, and the investments within each are correspondingly different.

The goal of this objectives-driven “bucketed” portfolio is to help the client maintain discipline with the long-term investment plan. For example, a client might be more patient with a higher volatility, higher expected return investment if he or she knows that the investment resides within the “get-richer” bucket.

Core–Satellite Portfolios. In investment philosophy, an accelerating trend toward core–satellite portfolios is occurring, driven by the massive move toward separating the alpha and beta components of an investment strategy. In Figure 2, moving out the x-axis indicates the degree to which an investment manager can add alpha and moving up the y-axis indicates lower cost and better tax efficiency. Up on the y-axis would be the sources of cheap, tax-effective beta — index funds, exchange-traded funds (ETFs), tax-enhanced index funds, and so forth. Out on the x-axis are those investments that have the best opportunity to deliver excess performance — inefficient asset classes, concentrated and/or unconstrained portfolios, long-extension strategies, various types of alternative investments, and so forth.

The goal of core–satellite portfolios is to avoid what Jean Brunel refers to as the “muddy middle” — the place where many traditional active managers reside because they have only a modest opportunity to add alpha or tax efficiency (because of the multiple restraints on how they can invest) but charge an active management fee. Many traditional active managers are limited in their ability to go short, take on leverage, and they are frequently penalized for too much “style drift” or high tracking error — all of which works against them in being able to generate excess performance.

For their core portfolio, investors can obtain beta exposure through such cost- and tax-effective products as ETFs and index funds. Then they can invest the remainder of their portfolio in alpha-seeking, higher-fee satellite strategies. The result is a cost- and resource-rationalized portfolio that provides low-cost and tax-efficient market exposure while focusing the majority of time, effort, and fees on those strategies that have the highest potential to generate excess performance. This “barbell” approach has had a significant impact on the asset management business, as managers migrate toward one extreme or the other along this “alpha–beta” spectrum (i.e., producers of either cheap beta or expensive alpha).

Investment Management Trends

Asset managers are responding to the core–satellite paradigm shift by rolling out new strategies and products at a rapid rate. These include an influx of non-capitalization-weighted, tax-enhanced, or other “designer index” investment products; tax-managed programs, such as Unified Managed Accounts (UMAs); and a loosening of long-only constraints for active managers (e.g., 130–30 or “long-extension” funds).

Hedge funds and alternative investments also continue to grow in popularity and usage in high-net-worth portfolios as investors seek a wider opportunity set for diversification and potentially enhanced performance. The introduction and growing popularity of registered or mutual fund–like funds and “feeder funds” is helping to fuel this growth by providing access to alternative strategies at lower investment minimums. Another fascinating innovation is “exotic beta” or hedge fund replication strategies.

Research supports the notion that much of the return of different hedge fund strategies can be quantitatively “replicated” using multifactor models and trading algorithms. These returns are thus not manager alpha but, rather, alternative or “exotic” beta. On the back of this research, many financial institutions have launched “alternative beta” or hedge fund replication products — all of which claim to be able to deliver the return streams of a specific hedge fund strategy (e.g., absolute return) at a lower cost than traditional hedge fund management fees. It remains to be seen how it will affect the pricing and structure of alternative investing going forward.

A survey by Capgemini/Merrill Lynch indicates that more than 2.5 million high-net-worth investors in North America control $8.5 trillion in assets.¹ Furthermore, 30,000 investors in North America are classified as ultra high net worth, which means having greater than $30 million in assets, and this segment is growing faster than the overall high-net-worth market.

Despite the obvious opportunities these numbers imply, the wealth management industry remains highly fragmented, with no dominant brand or “go-to” shop. Only 20 percent of advisers at larger banks or brokerage firms say that they control more than 60 percent of their clients’ assets.² In contrast, my personal experience is that boutique advisory firms tend to control almost 100 percent of their clients’ assets almost 100 percent of the time. This is, perhaps, because the typical boutique firm business model of objective advice and personalized client service is what clients prefer.

That said, banks, brokers, and trust firms still dominate the landscape; boutiques collectively control only roughly 11 percent of the market. Banks, at least in the United States, still seem to be fairly far behind in bringing competitive offerings to the table, whereas brokers and trust companies seem to be doing a better job of figuring it out. The key to success for smaller firms (which lack the marketing and branding dollars of the larger firms) is to identify and exploit a specific market niche.

It has been said that there has never been a wealth management segmentation strategy that failed. There are firms that focus on telephone pole workers and others on the divorced spouses of Silicon Valley executives. A firm can succeed if it can identify a niche market that is narrow enough to dominate yet deep enough to be sustainable and then become the “go-to” brand in that segment. Niche players tend to focus on core competencies and outsource other required solutions. The wealth manager can then specialize, which means differentiation and higher margins.

Conclusion

The high-net-worth marketplace remains highly fragmented with no dominant player. At the same time, what clients want is fairly straightforward: They want institutional-quality investments and boutique-quality client service. This can be accomplished by those firms that identify their core competencies, segment and “niche” their service offering accordingly, and offer robust investment solutions that focus on delivering cost-effective, tax-efficient, objectives-based, and “alpha-rationalized” performance. The adviser that does this will deliver a differentiated and highly successful wealth management experience.

Scott D. Welch is senior managing director and member of the executive committee at Fortigent, LLC.

Figure 1. Using Sub-portfolios in Constructing on Objective-Based Portfolio

Figure 2. Basic Concept of Core-Satellite Portfolios