Managing client risk assumptions

By Mark Noble | September 16, 2009 | Last updated on September 16, 2009
5 min read

Since the risk tolerance of high-net-worth (HNW) investors has shifted dramatically, private wealth managers are now exploring different ways to present a portfolio to address the risk assumptions of the client.

Against a backdrop of angry clients and plummeting net worth, it’s probably fair to say that many high-end investment professionals have started to question whether the tenets of modern portfolio theory works.

That debate will be ongoing. What is clear is that regardless of how well diversified a portfolio is, clients are not ready to ride out the drop in their portfolios, says Tom Trainor, CFA and managing director of Toronto-based Hanover Private Client Corporation, a HNW multi-family investment practice.

“There are really two risks you deal with. There is the financial capacity of risk, which we can quantify. The other half of risk is the client’s emotional tolerance of risk. The latter is a big wildcard that came last year,” he says. “We know events like what happened last year are going to happen once every few decades. We can quantify that in our models.”

He adds, “Until clients get into the situation they don’t know how they are going to react. You have no way as an advisor [to know] how they are going to react. We have some clients who are extremely sophisticated, and I think it’s fair to say they were even surprised by their reaction.”

Monitoring risk correlation

Private wealth managers are looking to ensure their risk metrics are intact. Things can and will go bad in the markets; the key is to ensure that that’s accounted for.

One lesson learned from this last downturn is that numerous, seemingly non-correlated asset classes can still be triggered by the same risks. So certain events in the marketplace can send many asset classes down.

Stephen Horan, head of professional education, content and private wealth at the Virginia-based CFA Institute, much work has been completed in the past few months with identifying the risk correlations in certain asset classes, and making sure that assets in a portfolio are diversified not only across performance but also across their risk triggers.

“There is still reexamination of the notion of diversification. Fortunately, the discussion has matured from ‘Is diversification dead?’ to ‘How do you best implement modern portfolio theory?’ The fact is, correlations have always changed and we’ve kind of ignored that in implementation,” Horan says. “When it comes to alternative asset classes, there is a growing sophistication in thinking that, rather than diversifying across different classes, you diversify across different risk exposures.”

Horan points to evidence that, for example, private equity has a strong downside risk correlation to regular equities. When equity markets tank, private equity tends to as well.

“It’s still equities and it is going to be highly correlated with other equities in your core, publicly traded portion of your equity portfolio. That’s not diversification in the correlation sense,” he says. “It’s not an indictment or a validation or using private equity in the portfolio — it just might not be the best diversifier across risk exposures.”

Trainor points out that core asset categories held up in their correlations, so he’s not a big fan of alternative asset classes. Instead he focuses on the major capital allocations to equities, fixed income and human capital — the client’s income. For the HNW client, human capital comes heavily into play in supplanting losses in the portfolio.

“We’ve never been big proponents of hedge funds, simply because we really look at them as a sub-component of broader asset classes such as equity or fixed income,” he says. “In terms of all that, I think that one of the things is you go back to basic principles on capital allocation.”

Trainor adds, “If you had the bond portfolio structured from two years ago, you’re still clipping the coupon from two years ago. It was the short-term component of investing that changed. I think that was a big surprise for all of us and gave a lot of people angst. When you look at the basic principles [of diversification], they haven’t changed dramatically.”

Packaging risk

A portfolio can do everything right, but still result in a miffed client. This is why advisory firm Wellington West has worked closely to develop investment products with renowned behavioural finance expert Meir Statman, the Glenn Klimek professor of finance at the Leavey School of Business at Santa Clara University.

Wellington West recently launched its Nxt Funds products, which are only available through the firm’s advisors. They are designed to combat the destructive behavioural tendencies of clients.

Sam Pellettieri, chief investment officer of Wellington West, says the funds are essentially HNW wrap programs that are firmly rooted in modern portfolio theory, offering a high amount of diversification and hopefully good long-term performance.

The packaging is unique, Pellettieri adds.

“Some firms, when they create products like these, create the wrap and have the client pick a number of fund mandates,” Pellettieri says. “We deliberately launched this as a single ticket solution. Really, that’s where the first level of behavioural finance came into play. When you give somebody a portfolio of customized asset classes, what starts to happen is that people start to look at their asset mix in a very myopic way.”

Pellettieri says clients have a tendency to dwell on single investment decisions within the portfolio, rather than looking at the performance of their entire portfolio. Eliminating this allows them to focus on the long-term performance of the portfolio.

“Clients will look at four investments within a portfolio that haven’t done well and tell their advisors to allocate what’s left of those to the three that have done well,” Pellettieri says. “Clients want to make decisions based on the individual parts without understanding how those parts fit into a diversified whole portfolio.”

Statman has also helped Wellington West retool its client reporting materials to minimize investor anxiety, Pellettieri notes.

“[Investment funds] tend to report performance versus benchmark, and say they are down 10% or 12%. Do investors understand if that’s a normal rate of return or an abnormal rate of return? What does that mean? To them it’s not very meaningful,” he says. “What we’ve done is create bands of expectation of one-, ten- and 15-year holding periods of what the normal band of returns should be for a given holding period. This way, when they open their report and see they are up or down, this rate of return falls within the expectations that Wellington West set out in the report.”


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