Should you re-jig clients' asset allocation in volatile market conditions or is it better to sit tight and leave it be? Rebecca Jones investigates...
You have explained risk versus reward to your client, established a risk profile, gauged their capacity for loss, allocated assets within their portfolio accordingly and, every year, you will revisit that - job done. Or is it? What if, for argument's sake, a similar situation to that of 2008 happens and, despite your best efforts, market movements mean your client's portfolio sheds 30% in a year?
In that scenario, do you sit tight, assuming the market will bounce back next year, or do you try to mitigate those losses by changing the client's asset allocation as soon as possible? According to some, the former - static asset allocation - is just not fit for purpose anymore, while the latter - active asset allocation - is the key to maintaining risk profiles, limiting losses and cultivating good relationships.
Of course, before you decide on whether or not to fiddle with a client's asset allocation, you have to establish it. For many, including Joss Harwood, director of Eldon Financial Planning, this process begins with a risk questionnaire. Harwood uses Finametrica's version, which she claims gives a reliable indication of "how people feel about investment risk and how uncomfortable they feel when markets go down". Overlaying that with conversations about long-term goals and income needs, Harwood then allocates assets within the client's portfolio, re-assessing annually and tweaking only to bring assets back in line with the original allocation.
Harwood's portfolio construction and management method is typical; tried and tested by the masses and not yet proven wanting. But is it enough? Ed Smith, global strategist at wealth manager and DFM Canaccord Genuity, does not think so.
"If markets are relatively benign and you have done a good job in the first place, you will probably have to change the portfolio very little. But static asset allocation, where the portfolio is going to look the same regardless of what is going on in the markets, is a really bad way of managing risk in the portfolio," he says.
Maintaining risk, capping losses and keeping clients
Smith's argument essentially hinges on the fact that, in changing market conditions, the financial crash of 2008 for example, a typical 'cautious' or 'balanced' portfolio is not going to remain so. In those conditions, a 20% exposure to equities could be devastating and what advisers and managers really need to do is be active, perhaps moving everything into fixed income, cash and gold. Not only, Smith argues, will this mean the client's risk exposure remains in-line with originally agreed limits, but it should also help to cap losses well before they reach the 30% mark seen during the last crisis.
In response to this argument, many will point out the obvious fact that, in 2009, most investors who sat tight recouped those losses and then some when markets swung back, which typically happens following a crash. However, for Smith, this is beside the point.
"Even though markets came back quite aggressively, that is still a very rocky ride for that client, involving a high degree of volatility that they may not be willing or able to tolerate. If they have a balanced risk profile, that means they cannot really suffer 30% losses and then 50% gains the next year - that is not what their personal circumstances require," he says.
There is also, as most of us know, an emotional toll when it comes to losing money - one which the cautious, balanced and, in some cases, even the high risk investor may find difficult to bear. Thus, hefty losses could put strain on the adviser/client relationship, argues Smith.
Mike Horseman, director of Cockburn Lucas, agrees on this point.
"Every client is cautiously greedy. When we are making money for clients, you don't hear from them, but watch the phones go off when they're losing it. Bear in mind that your client will feel the loss ten times more than the gain and think about your reputation," he says.
Market timing versus investment, breaking agreements and high costs
However, some argue that what Smith is essentially advocating is market timing, which, as Harwood observes, is notoriously difficult to get right and generally the antithesis to good investing.
"Even if you thought it was a good idea to get out of shares and then you are celebrating because the shares are being sold, the next question is, when do you get back in? All the research shows that people cannot get out and get back in repeatedly and beat the market, and we stand by that. The money that is invested through us stays invested," she says.
What's more, Harwood argues, that to change a client's asset allocation, even in stressful market conditions, would potentially violate the original agreement made with the client at the outset. Far better, she claims, to ensure the portfolio is continually re-balanced so the client's allocation remains as static as possible, a process her firm undertakes twice a year.
"We keep a constant eye on portfolios, making sure the asset allocation we agreed stays that way unless the client's circumstances change. We would not go in and change the underlying funds by trying to guess the market as that is not what was agreed," she says.
But how do you explain the sort of losses seen in 2008 to a client with a supposedly cautious portfolio? For both Harwood and Horseman, who also favours re-balancing to re-allocating, the key is to thoroughly explain these risks to the client at the outset.
"When I get a client come out as a risk profile of 7, I ask them whether they realise that means they could, in theory, lose 25% of their capital in a year. Most of them will say they would be devastated by that and so we re-programme the risk score," says Horseman.
He claims a particularly useful way to demonstrate potential loss is to 'back test' the current portfolio in order to see how it would have behaved in the 2008 crash, which is still fresh in client's minds.
Harwood's final argument against tinkering with asset allocation in a crisis is cost, as every trade will inevitability add up. In a period of loss-making, that is far from helpful.
However, Smith claims that, overall, the strategy should pay for itself.
"In the years you have to make big changes, such as in 2008, there may be some slightly higher trading costs than a normal portfolio. In more benign years, however, you would not have to change the portfolio so much," he argues.
Active management, as most advisers know, is a hotly contested investment method. Yet, there is certainly something attractive about the idea of capping losses and smoothing the ride for investors in a crisis, particularly for advisers interested in holding on to clients. The question is, however, whether it is one worth striving for.
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