How much risk can they take?
A client’s risk tolerance threshold must be taken into account before the wealth manager can build a successful and suitable portfolio. Roxane McMeeken reports on the delicate process of risk profiling.
Managing risk in client portfolios is a tricky tightrope act that wealth managers must perform successfully. If they lose their balance, they risk losing the client. Wealth managers tiptoe a fine line between the changing stated requirements of their clients and the equally fickle market environment.
Conversations with investment counsellors at Europe’s top private banks reveal that each has their own strategy for distinguishing between what clients say they want and – given market conditions – what they actually want. It’s a delicate process, fraught with the danger of patronising and offending the customer.
“Managing expectations” has become the phrase of the moment amongst the wealth management community. The popularisation of this euphemism, which really means “ensuring your client is in no doubt as to what he or she stands to lose”, highlights the new emphasis on risk.
The bear market, now hopefully receding, has tested clients’ risk tolerance to the limit. Peter Stanyer, managing director for product
analytics at Merrill Lynch International Bank remarks, “clients who feel they were badly beaten up by the markets in recent years have found their risk tolerance was lower than they thought”.
Even before the bear market, clients wanted low risk access to investments returning higher than government bonds, according to Mr Stanyer. It is not possible to provide this, he says, without incurring higher levels of risk. Clients need to be persuaded of this, and this is where “managing expectations” comes in.
Short term views
Clients tend to be reactive and take shorter term views, regardless of their investment time frames. Mr Stanyer says that “now, people want to be 100 per cent bonds. Three years ago they wanted to be 100 per cent equities”. Merrill advises neither position, whatever the market conditions.
Recent experiences have left most clients more tuned in to risk. “Clients are far more nervous,” says Jeremy Smilg, executive director, investment consulting, UBS Wealth Management. “They are far more anxious to understand how their portfolios are running.”
He adds that there are some areas where clients’ perceptions need to be challenged, however politely: “Clients sometimes state that they are long term equity investors, but are in fact only able to maintain strategies for very short time periods if the strategy does not produce rapid results.
“At the opposite end of the spectrum,” says Mr Smilg, “clients frequently look upon cash sitting in a current or short term deposit account as a nil risk asset and are happy to ignore the fact that they may well be earning negative returns after tax and inflation.”
Even after three years of deeply troubled markets, some clients are still insufficiently aware of risk.
Emmanuel Fievet, head of investment counselling, Europe, Citigroup Private Bank, says: “Many investors remember the excessive returns on equities in the late 1990s and some still regard this as the norm, leading them to disregard risk as they chase gains. We have all seen real life illustrations of ‘irrational exuberance’ in bull markets. When markets are galloping ahead, the fear of missing out on the bonanza seems to be the main concern. This can lead to rather an irrational attitude towards risk.”
The full picture
To counter this, Mr Fievet argues, clients need to be given the full picture: “We want our clients to be fully informed and comfortable with where we put them on the risk/return spectrum. That includes the risk of losing money of course but also the risk of missing out on potentially lucrative opportunities. The risk of regret must be taken into account.”
‘When markets are galloping ahead, the fear of missing the bonanza seems the main concern’
Emmanuel Fievet, Citigroup Private Bank
Tackling risk
The consensus among wealth managers is that risk should be viewed from a number of different perspectives. At Citigroup, explains Mr Fievet, risk is assessed in terms of broad asset classes, sectors and countries on the one hand and specific holdings on the other. But he adds, “some other sources of risk are not even intrinsic to the holding or the asset class it belongs to.
Sometimes the biggest risk comes from the investor’s outlook and behaviour. An investor who keeps erratically changing their investment time horizon is bound to lose money regardless of the quality of the investment vehicle.”
The flagstone of all risk management is diversification. Citigroup favours adding alternative investments to a portfolio of traditional investments. But to counter the addition of these asset classes, which are themselves usually seen as riskier than more mainstream instruments, further action is taken.
“Some alternatives, such as private equity, are illiquid,” says Mr Fievet. “They are therefore very difficult to compare to traditional investments. To tackle these challenges we draw on Citigroup’s internal resources, as well as specialists at leading academic institutions for advanced quantitative and qualitative research.”
He stresses that the client’s entire assets must be looked at, not just those they hold through the bank:
“The wealth of many entrepreneurs and company executives often is dominated by a single holding of a quoted equity. A strategic asset allocation must clearly consider the risk arising from this single holding.”
World's top 5 private banks
Ranking
Bank
Total AUM
1
UBS
$1012bn
2
Merrill Lynch
$818bn
3
Credit Suisse
$366bn
4
Citigroup PB
$180bn
5
Deutsche Bank
$153bn
Figures are based on preliminary findings in Scorpio Partnership’s survey of assets under management at the world’s private banks as of June 30, 2003. They may differ slightly from those in the forthcoming Scorpio survey, available at the end of September. The numbers for Merrill Lynch and Deutsche are informed estimates.
The exposure must be hedged out in close co-operation with the client’s tax adviser, says Mr Fievet, in order to ensure the hedging is carried out tax efficiently.
Once the portfolio is up and running, Citigroup’s risk management approach is to use proprietary models to build portfolios, although some of the tools used in this process are made and maintained by external vendors.
‘Clients who feel they were badly beaten up by the markets in recent years have found their risk tolerance was lower than they thought’
Peter Stanyer, Merrill Lynch
Conservative attitude
Merrill Lynch has a slightly more conservative approach to risk management in client portfolios, seen, for example, in its attitude to alternative investments. For cautious clients the maximum portfolio allocation to hedge funds is capped at 10 per cent – relatively low for high net worth investors. Even more aggressive portfolios are restricted to a maximum allocation of 25 per cent.
With sometimes ill informed and occasionally “irrational” clients on
their hands, the trick for wealth managers to pull off is establishing the client’s true risk tolerance before tough markets reveal that it is lower than at first thought.
Portfolio to match
Once an appropriate risk profile has been drawn up, the portfolio is designed to match it. At this stage, banks agree that it is critical to ensure the client is aware of the worst possible scenario that could result from his or her set of investments.
The leading private banks each begin this process by asking the client to complete a detailed questionnaire. This should establish whether the client has a desire to accumulate wealth or preserve wealth, says Merrill’s Mr Stanyer. The relationship manager will then try to put a score to each client’s level of risk tolerance and to agree on it with the customer.
“In a series of conversations we try to get the client to understand their own risk tolerance and their psyche,” Mr Stanyer reveals. “Often it is necessary to persuade clients that what they should be doing is not necessarily what they want to do.”
While leading private banks match customers to a particular risk category and then to the corresponding asset allocation model, Mr Stanyer stresses it is important to go further than this. Wealth managers, he believes, must tailor the generic asset allocation model to the client. This means hedging out any of the investor’s holdings outside the portfolio.
Mr Stanyer also advocates drilling down into the detail of the asset allocation: exactly what sort of bonds should the client be holding in the fixed income section of the portfolio and in the equity section, which regions should be represented and which market caps.
At Merrill another aim at this initial stage, adds Mr Stanyer, is to establish how involved the client wishes to be in the investment process and to accommodate all levels of participation.
Science and art
The Credit Suisse Private Bank approach to assessing client risk tolerance and then running the resulting portfolio is based on a mixture of science and art. Risk tolerance is assessed in terms of the client’s “experience, interest, expectations, risk awareness and ease”, explains David Strebel, senior asset adviser at the bank.
When it comes to building the portfolio, the defining factors are a mixture of the standard strategy designed by Credit Suisse to fit a given risk profile, the personal preferences of the client and the house view of the financial markets.
An in-house application is then used to assist the client relationship manager in monitoring the portfolio. It highlights any deviations from the agreed investment strategy as well as any new investment opportunities.
Risky Balancing Act
Peter Stanyer at Merrill Lynch Private Bank has no doubt thought long and hard about risk management. He is the former head of performance and risk management at Mercury Asset Management.
In the winter of 2001 he and his team were hauled over the coals when a major client sued the firm, by that time named Merrill Lynch Investment Managers, in a case that rocked the institutional fund management industry.
Unilever’s UK pension fund accused MLIM of negligently taking too much risk when managing Ł1bn (e910m) of its assets between January 1997 and March 1998.
After contesting the claim, MLIM settled out of court, handing Unilever an unprecedented payout estimated at Ł70m.
Part of the case revolved around the techniques of fund manager John Richards, who claimed sensationally not to need quantitative methods to assess risk.
Today, Mr Stanyer advocates a slightly more cautious approach. He says that Merrill’s private bank does measure risk, but there is no set policy for risk measurement based on quantitative economic models. Instead, he favours a “back to basics” approach.
“We have used formal risk systems, but it has become apparent that basic statistical back-testing of investment strategies works better,” he says. Portfolio design is governed by an overriding “barbell” model, which ensures all portfolios have some conservative assets at one end of the bar and some risky assets at the other, however conservative or pro risk the investor may be.
It is also a matter of simple good judgement, he adds. “We do not move portfolios around too frequently, but we are willing to make bold moves. Last autumn we had a policy of substituting clients’ equity allocations with investments in high yield (although now we think high yield is expensive). After all the pain clients have been through, we did this because the risk of losing money in well diversified high yield was lower than in equities.”
Mr Stanyer notes that since the markets turned sour, compared to institutional investors such as pension funds, “private banks have been much more nimble-footed in terms of changing the risk profiles of their clients. In the private client world, negative figures really do mean losing money, so strategies have become much more cautious and have shifted towards alternative sources of alpha.”
