Cut To Fit

The number of affluent individuals in the United States and worldwide continues to expand, bringing a host of new clients seeking professional guidance from an investment advisor. As I have argued before in these pages, notably in “Great Expectations” (December 2003), an advisor ready to capture that segment of the market must prepare himself to face the changing needs and wants of the wealthy. The universe of investment options is changing–and growing–at a rapid pace, surrounded by an increasing web of rules and regulations that must be untangled. Moreover, the scope of the typical investor’s assets and management needs is changing as well. Clients are as interested in saving for future college tuition bills and adventure vacations as they are concerned about retirement. They are likely to ask for your help in fitting toys like yachts, personal jets, or second homes into their greater financial plan.

Resolving the resulting patchwork of issues presented to an investment advisor requires a well-researched decision-making process. Finding the methods and products and vehicles that allow the advisor to provide this high level of service is anything but easy or straightforward; even a dedicated, experienced advisor’s standard practices can fall short of the mark.

I like to think of this as a “Twinkie” issue. If you give a Twinkie a whirl in a blender and compare its pre-blend volume with its post-blend’s, you’ll find that the little cake is almost 70% air–pure dead space. Similarly, conventional investment advisor wisdom, while offering clients a host of wonderfully structured resources and intelligent-sounding advice, often falls short when it comes to the substance and details of portfolio design and implementation.

It’s easy to get stuck in a rut, applying standard, easy solutions to each client. However, sticking with a static list of mutual funds or a fixed view of asset allocation is unlikely to suit the needs and tolerances of every investor. Although a cloned investment plan might feel “close enough” to fit the bill, both a client’s portfolio and the client-advisor relationship can reap immeasurable benefits from a plan that takes personal nuances into consideration.

A classic cookie cutter example is the standard 60-40 stock-bond portfolio allocation. Although the model has its merits, it is not the perfect solution for all investors. Consider the client who is severely risk-averse, or the client whose assets under management represent only a fraction of his net invested dollars, some or most of which are already allocated to stocks and bonds via other platforms. Even a cursory consideration of these cases shows that they don’t fit the mold and require personalized advisor attention.

Are you proud of your financial plan prowess? If you think you can relax once you’ve formulated a great plan for a client, in the real world of constantly evolving financial markets and products you’d better think again. Not only should an excellent investment plan adjust from one investor to another, it must evolve over time. An advisor with allocation techniques based on research of several years ago or market conditions of similar vintage risks advocating client portfolios with marginal risk and return profiles.

Financial developments in recent months provide obvious examples of how up-to-date research will affect choices in both allocation structure and exposure. A force that could change the mechanical side of portfolio construction is the emergence of hedge fund index products and the new perspective they provide on alternative investment exposure. Whether the advertised performance of these hot new instruments conforms to a client’s financial goals is a question that requires research on the part of each advisor. Similarly, the rapidly changing interest rate environment should prompt a review of the asset class allocation of a portfolio. New research may reveal techniques for effective rising-rate protection unique to the current total economic landscape, such as incorporating or increasing allocations to adjustable rate mortgage or bank loan funds.

Here are two common mistakes that can occur if an advisor takes a static approach to solving client problems:

Neglected Implementation. Simple adjustments like periodic rebalancing and tax harvesting can be excellent ways to enhance a portfolio’s total performance. The existing research on the subject makes it tough to deny that a regular application of these techniques can boost portfolio returns and, more important, reduce both portfolio volatility and tax liability. These and other investment management “chores” are easily neglected, and often are. With a large book of clients, all with varying market exposures of varying durations, putting these practices to work can become a time and resource hog. Postponing the process, or applying it willy nilly, can dramatically reduce or negate the possible benefits. For example, rebalancing and tax harvesting should not be performed independently. A blind rebalancing might impose taxation that far outweighs the excess returns anticipated, and vice versa. Thus a case-by-case analysis is often necessary.

Avoiding Communication. Just as the markets evolve, so do a client’s needs, desires, and resources. If an investment advisor does not make regular client contact, it is likely that changes in income, assets, or other issues of importance will go overlooked. In addition, fostering a strong client relationship must include keeping investors abreast of market conditions, offering explanations when performance is poorer than anticipated, and reaffirming the stated goals of the portfolio. Sidestepping the sometimes traumatic interfaces with clients may save some time and energy in the short run, but can ultimately lead to a great divide between investor and advisor.

The Model Advisor

Avoiding the pitfalls that lead to vacuous investment advice begins by rethinking the fundamental role an investment advisor can play for his clients. In addition to addressing the points above, an advisor that aims to expand the traditional view of service from just “advice for a fee” to something greater, can find a truly effective path to excellent wealth management. Incorporating a little scientist, a little psychologist, or even a little motorcycle cop into an advisor’s repertoire of financial skills yields an advisor as diverse and talented as the portfolio he aims to create. Here are four job descriptions that the custom advisor can fill:

1. Pie Slicer. Investors and advisors alike recognize the importance of keeping their eggs in more than one basket. The real dilemma, of course, is which baskets to use. Top-notch advisors have investment methodologies available to their clients to dynamically diversify their investment exposure over many markets and asset classes to achieve target returns with reduced risk. In addition, a well-educated advisor can add a level of sophistication to the portfolio, enhancing elements like mutual fund selection and the application of advanced theories of portfolio design. These practices will vary both between investors and as market conditions evolve. Regular client communication and technical research are necessary to gauge the appropriate distribution of dollars.

One of the most challenging diversification questions is to determine if alternative investments such as hedge funds have a place in client portfolios. If advisors see their role as matching a client’s budgetary needs with a targeted return, then steadily performing investments could provide some benefit. But there are added responsibilities and expenses associated with alternatives. In addition to added alpha come K-1s, performance reporting issues, and a plethora of additional operational challenges.