A more sophisticated approach to meet multiple objectives

Ten years ago, it was obvious in the context of investment what core and satellite portfolios meant. The core would generally be a large passive portfolio, delivering stock market beta, while a group of satellites would be looking for alpha from either active management or alternative asset classes.

However, the credit crisis has helped boost professionalism across the board, and the traditional core/satellite arrangement is being superseded by an array of heterogenous solutions, as wealth managers develop more sophisticated approaches to deal with the difficult climate and disappointed clients. Asset managers are leading the way, but private banks are keen to play catch up, with groups such as Pictet increasingly channeling expertise developed with pension funds and institutional investors to their high net worth clients.

Improving construction

At Société Générale Private Bank, for example, Stéphane Wathier, global head of Portfolio Management, has arrived in Paris from the Luxembourg subsidiary, with a brief to improve portfolio construction. “Asset allocation is probably well applied in asset management firms but not so well in private banking,” says Mr Wathier.

“Although there is good capability, there is a big variance in portfolio management and many different techniques are used. The first problem we encountered was that clients often ask for concentrated portfolios but it is difficult to master risk in this type of portfolio,” he explains.

“Five years ago, we built up a strong process of selection with two main goals – a portfolio with a maximum of 30 to 40 names and a strict approach to risk. The process is based on a quant screening tool that ranks and selects stocks to build up a core portfolio based on fundamental criteria, and then to subject those names to The APT Risk Management Tool (ART) to produce a portfolio with roughly 20-25 names. This portfolio is rebalanced on a monthly basis. To this core portfolio, we add a satellite portfolio – which we define as a conviction portfolio of 10-15 stocks, which is very important from the client’s point of view.”

Société Générale Private Banking implemented this strategy in Luxembourg in 2004-5 and is now in the process of rolling it out across the private bank. “I’m convinced our experience in Luxembourg delivered good performance,” says Mr Wathier. “The problem we often encounter in private banks is that portfolio management is either centralised or delegated to the client relationship manager.”

If centralised, then there is a need to somehow define asset allocation and core portfolios while giving freedom to the local manager to select some stocks to ensure he remains comfortable with the situation, explains Mr Wathier. “But you can see, especially in Switzerland, often it is the client relationship manager – the commercial side – who does everything related to portfolio construction. Our position is to push the portfolio management more towards the client and to structure the investment process, even though we drive it, so the local manager builds the portfolio but within the rules of a strict investment process.”

Changing attitudes

The crisis has transformed investors’ attitudes to their wealth, and pushed wealth managers to take greater interest in client objectives. “The overarching trend we’ve identified over the last two years is our clients’ desire to compartmentalise their wealth, so one thing we’re doing is identifying clients’ needs in two categories – a lifestyle portfolio and a wealth transfer portfolio and for large clients segregating these two functions,” says Leo Grokowski, chief investment officer at BNY Mellon Wealth Management.

“As a reaction to the last two years, more clients want to see, feel and touch a portfolio that is dedicated to meeting their day-to-day lifestyle and their requirements through retirement. Before it was more about structuring the portfolio for the benefit of the next generation, so while for years the industry approached those two needs with one portfolio, now the short-term and long-term assets are often held in separate portfolios.”

The core lifestyle might for example include core equity portfolios, inflation hedgers and diversifiers such as managed futures, funds of hedge funds and 130/30 funds, while wealth transfer portfolios might include long- term assets such as private equity, aggressive hedge fund exposure such as single managers, concentrated equity portfolios, and distressed opportunities in real estate and loans.

This is an example of a larger trend variously called ‘purpose-driven investing’ and ‘objective-driven investing’, which aims for a complete and thorough understanding of clients’ balance sheets and future liabilities. This improves the dialogue with the client using terms they understand, rather than complex jargon such as Sharpe ratios.

Portfolios are usually then designed to comprise five different buckets: principal preservation, inflation protection, income accumulation, capital growth and enhanced appreciation.

A well-known advocate of structuring a portfolio around discrete buckets for different broad investment aims is Professor Amin Rajan CEO of Create-Research, who has suggested in a report Exploiting Uncertainty in investment markets, a methodology based on a multi-manager/core-satellite approach expanded to five buckets covering multiple client objectives. The bucket approach looks at each asset class at the most granular level to understand its moving parts.

“Investors have progressively become disillusioned with the old approach,” says Mr Rajan. “The core-satellite approach was not working, as actual returns diverged markedly from expected returns for most asset classes, and neither was diversification, as excessive leverage ramped up correlation between historically uncorrelated asset classes,” he explains.

Old-style diversification, focusing on a basket of asset classes, is either dead or gone into a long hibernation, says Mr Rajan. The old focus on asset classes is now being replaced by that on end outcomes, via a pragmatic asset-liability optimisation that runs with the grain of uncertainty that has descended on today’s investment landscape, he explains.

“The core-satellite model assumed that, being safe, the core assets will have low returns and satellite ones will have high returns, being more risky. As such each asset class in these two buckets had clear return expectations based on past experience,” says Mr Rajan.

“However, in reality, the actual returns diverged markedly from the expected returns in the last decade. The model lost its credibility and came to be seen as a marketing ploy to flog risky assets. The real problem was the risk-return characteristics of different asset classes progressively became volatile and unpredictable. Clients didn’t know what they would get from their investments and when they would get it.”

A more focused approach

Not everyone would completely agree with Mr Rajan’s thesis, however. “We pursue a more focused investment approach as too many buckets in our view will be dilutive as their value proposition may in reality not be sufficiently distinctive,” says Hans-Peter Huber, head of Portfolio Management at Julius Baer.

“We apply a multi-manager approach but are focussed on specific longer-term themes, such as emerging market growth opportunities, or proven investment styles such as value investing, which are structured in a complementary way combining active and passive as well as relative and total return based strategies along the overall concept. Using these strategies as building blocks in the framework of a structured investment solution allows us to flexibly adapt the overall concept to a very individualised investment scheme for a client. The beauty of such a structured approach consists in its modularity which allows distinct performance attribution analysis for all building blocks.”

These developments demand a greater effort to look under the bonnet at asset classes to derive a clear understanding of their behaviour. “What we’ve seen in the market post 2008 is a tendency to look beyond the portfolio asset allocation and try to understand the actual market exposures,” says Roberta Gamba, head of portfolio construction EMEA at JP Morgan Private Bank. “For example, if there is a hedge fund in the portfolio, to ask what the underlying exposure really is,” she explains.

“A client may aim to be underweight equities, but focusing only on their long-only exposure might not realise that they have equity exposure in their alternative investments, via private equity or hedge funds. By looking beyond the asset class and to the actual driver of its performance, we can better understand the positions we have in portfolios,” says Ms Gamba.

“We have also developed a proprietary tool based on regression, which helps us gain an insight with respect to the actual market exposure we have in portfolios. This is quite a new approach for private banks but is commonly used by asset managers and hedge funds to identify market opportunities. We generally use it as a due diligence tool, for example to examine a hedge fund strategy, and for portfolio construction purposes.”

Wealth managers are also expanding their solution sets to offer more opportunistic and tactical strategies in the belief that alpha is more difficult to capture in range-bound markets, and periodic miscalculations are more likely to occur in current uncertainty.

“Efficiencies in the market are more apparent than real,” says Schroders’ product manager for multi-asset Justin Simler. “High net worth investors are therefore moving away from traditional market cap weighted indices, because market cap benchmarks and benchmarks in general are an inefficient way to allocate money. Investors are looking more for absolute returns.”

Use of exchange traded funds (ETFs) also continues to accelerate, often to take tactical positions, as well as longer term positions in the most efficient or illiquid markets. “We’ve seen many wealth managers developing portfolios or funds of ETFs, where in-house asset allocation decisions are implemented solely or predominantly via ETFs,” says Claire Perryman, vice president at iShares. “This is to meet demand from clients for simple, inexpensive, liquid and transparent ways of expressing their views.”

Stéphane Wathier, Société Générale