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Boring No More

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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.

Burns and Huxley argue that “risk tolerance” is the wrong criteria upon which to base retirement portfolio allocations. Because most retail clients still need substantial growth in their retirement portfolios, they need to keep as much of their nest egg in equities as possible. And there’s the rub: How do you determine the smallest bond allocation that’s still sufficient to meet a client’s needs? Their answer is based on several basic principles that institutional pension funds have discovered, the first of which is never sell any assets at loss.

Sound like a basic “buy low, sell high” cliché? Well, it’s actually deeper than that if we drill down a little further. Because, even today, most advisor-managed portfolios aren’t constructed with an eye toward taking the money out, advisors frequently have to sell assets to make the quarterly distributions that their clients depend on. What’s wrong with that? Well, nothing if those assets are up in value, and you’d be rebalancing out that asset class anyway. But what if the portfolio’s values are down, as many of them were from 2007 through 2009? Then, in order to make distributions, advisors had to sell at a loss. Even before 2007, many retirement portfolios were frequently forced to sell at losses to meet their distribution schedules, thus locking in those loses.

If large pension funds operated that way, their performance would plummet, and their mangers would risk losing their jobs. How the big boys avoid that unpleasant outcome, and what Huxley and Burns do, too, is to invest just enough of a portfolio’s assets in a basket of high-quality bonds so that their dividends plus the redemptions from any bonds that are maturing will cover the expected distributions, continually adjusted for inflation. That frees up a larger equity allocation to keep performance high.

Asset Dedication typically structures their baskets of bonds to virtually guarantee enough cash flow to cover client distributions for eight years, and then updates them every year. (While the value of the bonds themselves will go up or down with the markets, as long as the portfolios hold them to maturity, they’ll make the coupon rate, and never lose a dime: “Individual bonds give you a worst-case scenario,” says Burns. “You always get the coupons.”) That way, the portfolios have plenty of time to allow the maximized equity allocation to ride out even the worst of market downturns, such as ‘07 to ‘09—and to give clients sufficient peace of mind, allow those equities to stay fully invested. “Advisors whom we work with were surprised at the lack of client calls when the markets went down,” says Burns. “When asked about it, the clients responded: ‘What’s to worry about? We know our income is locked in for years.’”

The astute reader will have picked up on the fact that we’re talking about bonds here, not bond funds. Most advisors use bond funds for their bond allocations because they’re very convenient, provide ready liquidity, and most advisors don’t want to purchase and manage a complex portfolio of bonds. (It’s truly ironic that equity managers are considered the rock stars of the financial world, but compared to either fundamental or technical analysis, managing a portfolio of bonds—with the changing yield curve, and balancing durations, interest rate risk, inflation, and bond quality—really is rocket science.)

Yet, in return for the convenience of bonds funds, advisors give up the certainty of cash flow that is essential to maximizing a retirement portfolio. Bond funds mark their value to market every day, and advisors have no control over when fund managers sell assets and lock in losses, so there’s no guarantee that the portion of a portfolio allocated to bond funds will be sufficient to meet required distributions. That means that either sometimes equities may have to be sold to make distributions potentially at a loss, or portfolios have to hold substantially more assets in bond funds than they need, to insure against market volatility. Either way, portfolio performance will suffer.

The solution is for clients to own bonds directly, and for many advisors, that means using one of the small but growing number of bond management firms, such as Asset Dedication. The genius of Asset Dedication’s model, thanks mostly to Dr. Huxley and to the technological algorithms that he and Brent Burns have created, is that they can keep their bond allocations to an absolute minimum, and still be confident the portfolios will always make their distributions.