HARNESSING the power of the market

Private clients are making major asset allocation decisions without realising their significance and without appreciating the risks involved, according to Michael Strachan, CEO of International Asset Monitor, an institutional consultancy gaining increased traction in the private banking and family office market.

“People can make the right decision at the wrong time, or they think they have delegated decision-making to their fund manager,” says Mr Strachan.

But the funds manager is constrained by a restrictive benchmark, he explains, so the client has already made the most significant investment decision by choosing an expert in a particular asset class or investment style.

This means many private clients, despite having hired expensive wealth advisers, are in effect making asset allocations themselves, rather than allowing their private bank to do it for them. “A private client may have appointed Goldman Sachs to run part of their portfolio, but he has already decided how much to allocate to them, what to invest in and when to withdraw,” says Mr Strachan.

Risk is so central to portfolio construction, that clients should organise their risk profile first, before arriving at any concrete investment objectives, he believes. “Most people set their objective first,” believes Mr Strachan. “They might say: ‘I want to beat the MSCI index’, without even considering their risk profile.”

But once they have set their objectives, most clients fail to understand the crucial role of asset allocation to the long-term performance of their portfolio. He believes that if they have strong convictions about different economies, these should always be reflected in the allocation.

And using exchange traded funds (ETFs) as instruments to reflect large positions is a further abrogation of responsibility, as the full value of a portfolio cannot be realised without actively managing its assets, he claims.

“A 16 per cent equity allocation to emerging markets in five years time is fully justified,” says Mr Strachan. “But if there are positive attributes to such a view, then you should already be at that allocation today. There is no justification in taking a 10 per cent negative allocation to an area, which will have the best growth after five years.”

The thematic approach

This is one reason why Mr Strachan believes a commitment to strong themes – dismissed by many investment managers and consultants, such as Mercer Oliver Wyman, as a gimmick used to sell products – can be a valuable expression of asset allocation positions to generate returns.

“The thematic approach has a lot of credence,” he says, drawing attention to a form of asset allocation and product selling made popular by smaller Geneva-based Swiss banks Pictet and Lombard Odier, as well as Zurich-based giant Credit Suisse. “There is tremendous added value in becoming more specialist. But who is making that decision about how much to put in each theme?”

Private clients are instinctively drawn to thematic investing, says Michael O’Sullivan, head of asset allocation for Credit Suisse Private Banking, which has identified many investing themes globally over the last five years, including scarcity of water, nanotechnology and alternative energy.

But the asset allocation process takes precedence, before the various compartments are then populated with the thematic products. “We start off with the idea or theme, then the basket of stocks comes after,” says Mr O’Sullivan. “Two years ago, we were looking at trends in ‘feeding Asia’ and we found that tastes were changing, which meant land use was changing and urbanisation increasing.”

Detailed research, including breakdowns of Chinese government statistics on tractor usage, was carried out before a basket of Asian stocks was selected to “play the theme,” says Mr O’Sullivan. “We launched the product in September 2007 and were very pleasantly surprised, as there was a strong rally in agriculture and commodity stocks at the beginning of 2008.”

There is no question of themes being cooked up to sell products, with each one the result of detailed research at a local level, he says. According to Mr O’Sullivan, critics of the process would be hard pushed to say the products used to implement the themes are overly complicated or expensive.

However, it is a waste of time digging up intellectually challenging investment themes if appropriate products cannot be sourced to exploit them. “Credit Suisse, as a bank, is careful to make sure its views are always investible,” adds Mr O’Sullivan.

The Swiss bank’s research department turned positive on equities in June, and from a strategic, 12-month point of view, has skewed client portfolios towards riskier assets such as equities and commodities and away from government bonds. Its strategists like sectors including IT, capital goods and energy, while defensive utilities and telecoms have fallen out of favour. In terms of investment styles, cyclical stocks are preferred over defensives, value over growth, small over large cap and emerging over developed economies.

While Mr O’Sullivan does not think the concept of ‘decoupling’ is necessarily an appropriate one, as most emerging economies are symbiotically linked to the developing world, he does say it is becoming increasingly easier to locate uncorrelated asset classes.

He believes the high correlations, between different equity sectors and styles, prevalent over the last 12 to 18 months have already started to come down. “This puts a premium on picking good stocks within different sectors,” says Mr O’Sullivan. “The issue of correlation, from a portfolio construction and management point of view, is something investors need to be very mindful of.”

Because correlations have been so high since the start of crisis, Christian Dargnat, chief executive of BNP Paribas Asset Management, suggests traditional diversification is not enough in current conditions, and clients need to divest themselves of assets in which there is little confidence. “Private banks don’t have to hesitate if they believe bonds are going down, but sell a big part of their [clients’] fixed income portfolios,” says Mr Dargnat.

Previously, bond allocations had to be maintained in order to hedge portfolios, but that is no longer the case in current, highly correlated conditions, which require a new approach. Although he believes decorrelation will come back soon, a more flexible policy is needed until the old certainties return. “If you dislike an asset class, then sell it,” recommends Mr Dargnat. “This is not easy and it’s not a mainstream part of asset managers’ thinking, but this is the main lesson we have learned form the crisis.”

BNP Paribas is looking at an institutional-style, liability-led approach to asset allocation, using a dynamic benchmark, which it believes can find favour in the private wealth sphere.

The asset management group has also been busy creating specialist products for the bank’s private banking arm, including closed end funds to benefit from high yielding corporate bonds in the first quarter of 2009. These products garnered E100m from BNP Paribas Private Banking and an extra E150m from other distribution channels.

Overall, the bank is continuing to use a passive core/high alpha satellite approach as a basic model for clients. This must offer a combination of active and passive management in order to be successful. “The crisis is in no way putting this approach in danger,” confirms Mr Dargnat.

But there are voices within the industry, suggesting the role of traditional, long-only asset managers such as BNP PAM and its competitors is not just losing influence, but in danger of dying out altogether.

One of the loudest is coming from Lyxor, the French group, owned by investment bank Société Générale, which offers a fusion of ETFs and platform-based hedge funds at the heart of its quantitatively determined asset allocation solution. With liquidity being the order of the day since the crisis, the popularity of a passive, ETF-led core among private clients is increasing.

This is combined with a selection of alpha-grasping hedge funds on the group’s managed accounts platform, which is currently taking E30m to E100m every week, with E2bn of net new money added since the start of the year.

Quantitative optimisation tools are used to minimise ‘tail’ risk in alternatives and equity markets. Typically, 65 per cent of such a portfolio is invested in the ETF core and the balance in managed accounts with access to leading hedge funds.

The concept has been popular among clients who want a cost-effective beta core portfolio, surrounded by a tactically managed, rather than static, set of satellite opportunities.

Last year disappointed the majority of clients who turned to specialist long-only managers, believes Lyxor’s senior strategist Florence Barjou. “At the end of the day, if you allocated an equity bucket to 10 different long-only managers, you ended up with returns close to the index, minus fees. Many people, even the big institutions, are in the process of thinking about how to optimise their approach and make it more cost effective. They realise they shouldn’t need to pay 10 different managers, but just one.”

While the strategists at BNP Paribas believe that we are going through a temporary blip, where strategic asset allocation has lost its influence, the Lyxor team is convinced that this is part of a longer stage, lasting several years, where tactical asset allocation (TAA) is in the ascendancy.

“There are drawdowns of 40 per cent in one year, while markets can rise 50 per cent in six months, so investment for the long run is not really appropriate,” says Lyxor’s senior fund manager Stefan Keller. “TAA is very important right now and underlyings must be liquid to replicate this kind of allocation.”

He suggests a radical rethink in the way private clients structure their portfolios. “We would say forget about traditional long-only asset management; it’s far too expensive for what it brings to the portfolio,” says Mr Keller. “We are moving towards an allocation model where people are not willing to pay to perform like the index.”

Although Mr Keller’s spiel may at first glance seem somewhat self-serving, as it clearly backs up Lyxor’s business model, it receives support from independent consultants, including Investor Analytics (IA), a New York based risk consultancy specialising in advice for pension schemes on alternative investments, but branching out to include family offices and private banks in its client base.

“ETFs, which give access to market beta, combined with hedge funds for alpha – that’s a viable way to go, and I’m surprised it’s taken us so long to get there,” says IA’s CEO Damian Handzy.

But understanding the risk of the portfolio should be a key determinant of the asset allocation, he believes, concurring with fellow consultant Mr Strachan at International Asset Monitor. “When people try to make an asset allocation, there is a significant conflict between reason and emotion, even for the most sophisticated investors,” suggests Mr Handzy.

The key is to arrive at a decision with which both the logical and the more excitable parts of the brain can go along with. The problem is that risk-based disciplines are not always easy to reconcile with emotions. “Risk-based asset allocation is counter-intuitive to people not trained in professional investing,” he says.

“When it comes to private individuals who have made their wealth through success in business, if they have no experience of the investment arena, they will have a very hard time making a risk-based allocation.”

The risk management issues which were pioneered by the alternatives industry ten years ago are now slowly permeating into private wealth management, claims Mr Handzy. “It’s no longer just about putting a proportion of your portfolio in stocks and some in bonds – that’s not the game any more. You need some hedge funds, private equity, short and long-term asset in there. It’s a complex game and people are entering it without the knowledge and training.”

While Amin Rajan, CEO of consultancy Create-Research agrees that private clients are starting to behave much more like institutions in the way they are thinking about trade-offs between risk and return in different market sectors, he believes a reaction against alternative investments is likely and that the popularity of long-only management will grow once more.

“I can’t see allocations to hedge funds rising in private banks, as people are not going to be fooled again. Private clients held 60 per cent of hedge fund assets and accounted for 80 per cent of redemptions,” says Professor Rajan.

“These guys have very strong taste buds. If they don’t see something positive on the radar screen, they will just check out,” he adds.

According to Professor Rajan’s research, private clients are likely to go back to buying active equity strategies, high grade bonds, real estate, private equity and distressed debt. “These guys will remain active investors, but they will become much more opportunistic. Understanding the risks will become very important for them,” he says.