Craft better portfolios

What happens when an advisor meets a client with multiple goals, not all of which fit comfortably into one portfolio strategy?

It happens when a husband and wife have sharp differences in risk tolerance, or if there are children from a previous marriage.

Mike Vanderburgh, managing director of Newport Private Wealth, says some clients also have multiple investing goals within the context of a single portfolio. He cites a wealthy businessperson with assets in the $20-million to $30-million range who’d struggled to and an advisor.

He had multiple needs. He wanted to cover his living expenses, but also wanted to establish a foundation for charitable purposes. And,most intricately, he had three adult children for whom he wanted to establish trusts.

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He had multiple needs. He wanted to cover his living expenses, but also wanted to establish a foundation for charitable purposes. And,most intricately, he had three adult children for whom he wanted to establish trusts.

For a small but growing proportion of wealthy clients, the solution is an approach known as goals-based asset allocation, pioneered in the past decade by the U.S. investment guru Jean Brunel, a J.P. Morgan alumnus who edits The Journal of Wealth Management. He’s also principal of Brunel Associates, in Bonita Springs, Florida. (Until October, he was also CIO at GenSpring Family Office, which ranked 14th on Bloomberg’s 2012 family-office ranking.)

Jean Brunel’s goal-based asset allocation matrix

In developing a goals-based allocation approach, Jean Brunel uses four modules to create the various sub-portfolios: tax-aware with non-traditional strategies; tax-agnostic with non-traditional strategies; tax-aware with only traditional strategies; tax-agnostic with only traditional strategies.

Investments in turn are allocated to nine categories, depending on goals and time horizons: for lifestyle goals, short- and long-term; for non-lifestyle goals, medium and long-term capital preservation, liquid growth, long-term growth, and opportunistic; for internal assets, capital preservation and growth.

One risk in the goal-based approach, Brunel observes, is that each client may end up with such a highly specialized portfolio that advisors will be hard-pressed to make general rebalancing recommendations based on shifting investment conditions. He also urges advisors who try this approach to exercise caution if a client’s total assets produce more income than they need to meet all their annual goals. “Don’t assume they’re ready to gamble [the surplus].”

Instead of building a balanced portfolio that works backwards from a client’s stated return expectations and risk tolerance, Brunel argues in favour of deconstructing the asset allocation question by focusing on a client’s various sub-goals: lifestyle, dynastic, philanthropic and opportunistic (e.g., large acquisitions not covered by annual lifestyle budgets).

“[This approach] is always suitable because it is not an end product so much as it is a process.”

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The motivation, Brunel told a Global Wealth Management conference in Calgary last year, isn’t hard to fathom. Most people are better able to articulate their goals rather than their tolerance for risk.

What’s more, ever since the 2008 credit crisis, the investment environment has shifted radically, with periods when liquid assets proved to be unexpectedly illiquid, and supposedly foolproof absolute-return strategies posted sharp capital losses instead of guaranteed growth.

The new normal calls for a more nuanced approach based on a tiered system of goals. “It is the question of, ‘what is most important to me?’” Brunel says.

In a March 2012 essay published by the CFA Institute, Brunel noted, “each investor has not only a variety of goals but also different risk profiles to accompany each of those goals. Some of these risk profiles may seem almost contradictory, yet they are not exclusionary. They merely reflect normal human behaviour.”

Brunel continued: “Wealth management advisors must develop investment strategies to match their clients’ different goals and risk profiles” (see “Jean Brunel’s Goal-based asset allocation matrix,” above).

How this can work for clients

While advisors say clients are interested in Brunel’s method when they propose it, goals-based asset allocation is used infrequently, and mainly by sophisticated investors with large portfolios that are easier—and more cost-effective—to subdivide. “It’s a combination of a lack of awareness and that relatively few advisors think this way,” comments Vanderburgh.

According to Jerry Koonar, vice president and portfolio manager for Leith Wheeler Investment Counsel in Calgary, only about 5% to 10% of his clients currently adopt this philosophy, most of them in the high-net-worth category (over $500,000 for his firm).

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“Most families that deal with our firm take a global approach to their investment portfolio, meaning they don’t bucket different accounts in terms of their risk profile and asset mix,” he says.

Vanderburgh applied this technique with the client who had three adult children. The key detail: breaking down the clients’ goals, and then building sub-portfolios designed to satisfy each.

He began by establishing a conservative $5-million portfolio that yields about 5%and covers the client’s living expenses. He bought a selection of yield-bearing securities, including government and corporate bonds, dividend-paying equities, growth and income real estate,mortgage-backed securities, and a small allocation to private equity. “We can just put that away and never think about it.”

Newport has an in-house team that includes a CA with tax experience, a lawyer who specializes in trusts and an insurance specialist. With input from the adult children, Vanderburgh established one trust for all three.

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Those portfolios could be more aggressively invested because there was a 30-year horizon. One child found managing money difficult, so the trust stipulated that one trustee could monitor access to the principal. Vanderburgh counsels clients against trying to control the disposition of their inheritance from the grave, but says it is still possible to ensure that the funds get into the beneficiaries’ hands at the right moment.

With the foundation, Vanderburgh had to determine the philanthropic philosophy, beneficiaries, and cash requirements. The client had a lifelong interest in the use of biotechnology to develop treatments for certain diseases, and endowed the foundation with about $25 million, or a third of his net worth, to fund research.

According to Canadian law, the foundation must distribute at least 3.5%-to-5% of the value of the portfolio—up to about $1.25 million in this case—every year to maintain its tax-free status.

Vanderburgh says this client wanted the endowment to exist in perpetuity, and points out that in many families, such foundations serve as a unifying influence, with the next generation taking up seats on the board and overseeing disbursements.

The upshot: four customized portfolios, each with its own mandate. As Vanderburgh’s example demonstrates, the key to building a goals-based portfolio is for the advisor to draw out the client’s medium and long-term objectives in far greater detail than might be the case with a more conventional approach.

Priority and time must be factored in when setting goals

Draw out the goals

Olivia Woo, senior portfolio manager for private clients at Mawer Investment Management Inc. in Calgary, observes clients may not initially be forthcoming with the full range of their investment goals, with many stating that their primary goal is retirement savings.

“But then you probe further and see they also want legacy and charitable giving,” she notes. “Once you find out what these goals are, you want [to take] a bucket approach.” Each objective will have different time horizons and risk tolerances.

Brunel’s technique starts with establishing investment goals, prioritized by need, and assigning each a dollar weight based on the amount the client requires. The advisor works backwards from that starting point, he says, establishing a risk tolerance and target yield for each goal. In this way, the advisor can determine the required size of each sub-portfolio. “You size [it] by calculating the dollar amount you need to achieve the financial goal over time,” he says.

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As he assesses a client’s assets with an eye to creating a goals-based allocation formula, Brunel also distinguishes between internal and external assets—e.g., those intrinsic to the person’s own business holdings and operations and which they manage themselves (e.g., an apartment complex), as opposed to investments in various asset classes with their own risk profiles, which are managed by an advisor (shares of publicly traded companies, private equity, etc.). In both cases, such assets should be designated as either capital preservation or growth-based.

Higher inflation is coming: poll

CEOs of Canadian investment companies believe inflation will rise in the next 10 years to 2.8%, or almost 1% higher than the actual rate for the past decade, finds a survey of Portfolio Management Association of Canada (PMAC). That would offset bond returns, which averaged 6.2% over the last decade, but will only earn 2.9% over the next, respondents say.

Meanwhile, they predict global equities will earn 7.8%, up from 3.6%, and emerging market equities will return 9.1%. This is on par with the 11.9% actual return of the previous 10 years based on the MSCI Emerging Markets Index $CAD.

PMAC respondents still believe in the value of Canadian equities, saying they will provide a steady 7.4% return, down slightly from 9.8%.

“All investors should draw on these directional insights in making their asset allocation choices and consider the impact of higher inflation on their portfolios when making investment decisions,” says PMAC president Katie Walmsley.

The advisor then makes allocation decisions that link the asset type to the specific goal—such as placing income-generating investments in an endowment or a capital preservation sub-portfolio geared to lifestyle needs.

Time’s also factored into the structure of sub-portfolios, and those decisions aren’t only a function of client’s age. In some cases, Koonar notes, there’s a significant age gap between the spouses; with the elder looking at converting an RRSP account into a RRIF while the younger partner has a longer horizon that affords more risk.

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Brunel and others recommend a 15-year horizon for the lifestyle sub-portfolio, citing research showing that period typically produces the optimal return.

Tax implications also factor into the construction of a goal-based portfolio.

The sub-portfolios, for example, should reflect the spouses’ respective income levels, with the lower-earning partner more invested in fixed-income assets, and the higher earner’s sub-portfolio structured for dividends and capital gains.

Alternative strategies

Not everyone buys into the goal-based method.

Ian Dalrymple, an independent investment counsel for Raymond James, says he prefers to allocate among eight asset classes (Canadian/U.S. cash; Canadian/U.S. dividend; Canadian/U.S. growth equity; Canadian/U.S. fixed income; international securities), developing a holistic asset allocation based on the investment attaining a certain value over a prescribed period, as well as risk tolerances.

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The problem with a goals approach, in his view, is that “clients change their perspectives over time.”

Woo agrees, and knows from her own client roster that goals aren’t set in stone. During annual reviews, she reviews the allocation to determine whether the client’s plans have shifted—for instance, with their philanthropic objectives, or their views on a particular charity.

Brunel stresses advisors should regularly review goals and performance against benchmarks, which is easier to do with the shorter-term goals in the various portfolios.

Finally, Woo and Vanderburgh do not change their fee structures if they adopt a goals-based allocation approach, because the actual management of the portfolio is no different.

John Lorinc is a Toronto-based financial journalist.