Wealth management firms are revving up to lead their advisors and clients into the 2020s. This week, Mercer weighed in with recommendations on five emerging issues that are expected to affect the wealth management industry’s long-term success.
1. Diversifying between active and passive strategies.
In 2019, market gains were strong, and continued to favor passive strategies in many asset classes. Mercer noted that when active management falls out of favor, advisors and their clients are tempted to abandon active management in the search for higher returns. However, history has shown that diversified portfolios that use both active and passive strategies are key to constructing durable portfolios.
Mercer recommends that advisors continue to help clients understand how passive strategies can facilitate access to certain market exposures, and evaluate which asset classes are more conducive to active management. Active and passive strategies can complement each other in diversifying risk. Advisors and clients should consider the expected market environment and why active strategies might mitigate portfolio risk.
2. Searching for brighter returns.
How to generate returns for clients when absolute interest rates across the globe are at historical lows is a primary challenge for advisors. So wealth management firms are looking with keen interest at strategies once available only to institutional investors that are expanding into the retail segment. But given the complexity of some of these strategies, Mercer cautions advisors in their role as fiduciaries to be highly vigilant in their due diligence.
For one thing, this means understanding both how the investment will behave on its own and how it will contribute to the client’s portfolio in different market environments. In addition, for private market opportunities, advisors should evaluate the manager’s experience in sourcing investments and executing their strategy through realization.
Key elements of the due diligence are the fund’s structure, term, liquidity and fees, as well as the operational risk of the manager’s organization.
3. Have obstacles to private markets gone away?
As private and public markets mature, new trends are emerging that may influence future investment approaches. Investors have been pouring into private markets to capitalize on growing direct-financing and pre-IPO opportunities. U.S. companies are staying private longer, resulting in a big drop-off of listed companies, which has led to more capital for fewer companies in public markets. At the same time, retail-accessible vehicles have made private markets more viable for individual investors.
But with opportunity, Mercer says, comes risk. Both clients and advisors need education, it says. They should build diversified alternatives portfolios to lessen risk through exposure to a variety of investment strategies and managers. And they should participate in different market environments.
4. Looking to model portfolios.
Wealth management firms are finding it beneficial to outsource portfolio construction and investment selection, and many asset managers are taking advantage of this trend by building model portfolios using proprietary funds and ETFs. Mercer says these offerings present inherent conflicts of interest, and advisors in the role as fiduciaries must ensure that the model providers they select have proper governance in place.
Wealth managers should consider several things, including the third-party provider’s segregation of asset allocation, manager/investment selection and portfolio construction duties. They should also ensure that the resources and tools the provider uses are robust.
In addition, they should focus on the level of diversification across asset classes and factors, and on how active and passive management products are used, and understand the provider’s definition of environmental, social and governance factors and what it considers to be a fully sustainable portfolio.
It is also important for advisors to understand the manager’s processes for investment and operational due diligence, and to probe conflicts of interest — are there proprietary products within model portfolios, and what are the provider’s policies around fee-sharing and platform placement fees?
5. Viewing tax impacts through the correct lens.
In a lower-than-expected return environment, tax efficiency becomes a more critical investment consideration.
Advisors need to focus on what Mercer calls tax-aware and tax-optimized strategies, and they must understand return sources and associated tax treatment. They should review appropriate investment vehicles, and consider a unified managed account platform and tax overlay manager.
Advisors can build out models or find tax software to assist them in comparing estimated after-tax returns of available investment opportunities.
They should also focus on asset allocation between taxable and tax-deferred accounts; in the case of alternatives, this can materially affect portfolio returns and should be considered before approving or rejecting the investment.
— Check out 10 Tax Facts on Investment Income on ThinkAdvisor.