Over the past couple of years, retail portfolio management has undergone a self-examination not seen since the mid-1980s. Back then a well-allocated portfolio contained equal parts of oil and gas, and real estate (in limited partnerships), with some gold and maybe a few public storage units thrown in for good measure.
Today, advisors are faced with the twin challenges of a market meltdown during which the diversified equity and bond theory of asset allocation failed miserably, plus a growing percentage of clients in retirement who rely on steady quarterly distributions. The need for hefty regular cash outflows combined with the ultra-low psychological risk tolerance of folks who live off their savings makes the MPT strategy of “riding out” the financial downturn virtually impossible for many panicked clients and their advisors.
Consequently, for the first time in nearly 30 years, many financial advisors are taking a hard look at how they manage their clients’ portfolios, and are willing to listen to folks who are proposing alternative (in the broad sense) strategies. Two such people are Brent Burns and Steve Huxley, of Asset Dedication LLC in Mill Valley, Calif. In 2005, Huxley and Burns published a book aptly named “Asset Dedication,” in which they identified the flaws in using traditional asset allocation to create portfolios for retired, or nearly retired, clients. The events of the past few years have made them appear downright prescient. And while they’re not the only people to have come to this conclusion, their notion that portfolios should be designed backward—that is, starting from how to best take the money out—is slowly revolutionizing the way advisors manage retirement portfolios.
Steve Huxley is the brains behind Asset Dedication. In addition to being a co-founder of the firm, he’s also a professor of decision sciences at the University of San Francisco, where he’s taught in the School of Business and Management since 1973. His professional claim to fame is winning the 1988 Franz Edelman Award for Outstanding Achievement in Management Science (sort of the Nobel Prize for business operational research). He earned the Edelman for devising a system to more efficiently schedule the duty shifts of the San Francisco Police Department, saving the city some $14 million a year.
In more recent years, he’s turned his attention to collaborating with Burns to create computer systems that optimize retirement portfolios to lock-in the desired distributions while maximizing investment performance. Burns is no academic slouch with an MBA from USF, but his contribution to the partnership comes from his experience managing the family office for his own family and later, working with other high-net-worth families at Morgan Stanley. Through his informal exposure to retail financial advice at Morgan Stanley, he realized that sophisticated portfolio strategies which had been developed by large pension funds (for whom the payment of regular distributions as promised is essential), and which are readily available to the wealthy (trust-fund babies rely on their quarterly checks), had not yet trickled down to the retail retirement market. He partnered with Huxley to change that.
The essence of the Asset Dedication portfolio strategy revolves around two seemingly conflicting realizations: Only high-quality bonds can generate enough dependable income to satisfy most retirement demands without irreparably depressing a portfolio’s performance; and any bonds in a retirement portfolio drag on performance. To solve this conundrum, Burns and Huxley devised a system that maximizes the guaranteed cash flow from bonds, while minimizing the bond holdings within a portfolio.
Put another way, Burns and Huxley have found the solution to a problem that until recently, most advisors didn’t even know existed. We all know that bonds reduce the risk and offer diversification (usually) within a portfolio, which is why, since the late ‘80s, virtually all retirement portfolios managed by financial advisors have contained some portion of bonds. But because the long-term performance of bonds lags far behind equities, most advisors use a relatively low bond allocation for clients who are still in the accumulation phase, and then a somewhat higher bond allocation for retired clients.