A good financial planner can add value to clients' portfolios by assessing their aspirations and attitudes to risk and matching those expectations to an appropriate asset manager who will deliver the required results
Why does a financial planner need to be involved in portfolio planning at all? Surely, this is something for asset managers. That view is partly right and partly wrong. The financial planner's job is to match the most appropriate type of portfolio to each individual client's characteristics and aspirations. It is for the asset manager then to deliver results from the chosen investment portfolio. All too often the industry at large sees our ultimate consumer, the client, as just one of a number of categories. In truth, all clients are individual and so all of them have different needs. The financial planner's value is in understanding those needs and matching the client with the appropriate assets and the appropriate asset managers.
At present, those private clients are now more concerned about volatility in markets than they have been for many years. The volatility in markets, equities in particular, during the first three years of this century has had a marked affect on clients' attitude to investments. Quite understandably, clients are basing their investment decisions on the recent past rather than on future expectations.
Planning a portfolio
A fundamental part of the financial planner's work is to fully understand a client's mindset and to explore, through KYC, a client's investment aims and objectives together with their attitude to risk. Many clients, if completing a simple fact find, would invariably state that they are 'risk averse' but, quite contrarily, would be content to have their portfolio invested in the same fashion in a UK pension fund. In other words, someone who wishes to be 'risk averse' would happily have a portfolio which was partly invested in high risk investments such as equities. Of course, industry professionals will be well used to these contradictions but it is absolutely vital for the financial planner to achieve this clear definition of a client's aims and objectives before recommending particular portfolios. If the planner errs too much towards a cautious portfolio - with the inevitable mix of cash and bonds - then a poor long-term result is likely to be achieved. Swing too much towards riskier investments then the long-term return might be better but the intervening volatility might not be welcome.
The financial planner's fundamental job here is to ensure that the portfolio recommended to a client is in line with their realistic objectives and that can only come through a real mutual understanding.
Only then can the planner move on to a consideration of the other basics. For example, is income or growth required - if it is income that is needed, is the client simply concerned with the headline yield, or with the manner in which the income is produced? A UK commercial property fund will perform differently, in capital terms, in the future than a bond fund and yet the yields would be similar at the outset. Likewise, the client who wants equity derived growth is likely to have a different experience if they pick a thematic fund, rather than an index tracker.
The financial planner's job is to be aware of the differences and to be able to explain them to a client in a manner which helps the client make their own decisions.
More recently I have found clients concerned with the results of benchmarking - a practice common throughout the investment industry. Clients do find it hard to accept that negative performance can be reasonably explained relative to an index. All too often clients expect absolute performance and have not fully understood the mandates which they have given to managers in the past. Therefore, I view asset allocation as the most important element in the whole investment process. Studies have shown that portfolios containing more than one asset class tend to perform better, with lower volatility, than those heavily exposed to a single asset. That is particularly so where those assets are uncorrelated.
In considering the percentage to be allocated to each asset, the financial planner needs to revert to the client's investment objectives, as well as the time horizon and risk tolerance of the client. Clearly, no single asset allocation will work for everyone although as time passes clients tend to prefer a more conservative investment strategy, aimed at preserving capital and generating income rather than growing capital.
I find that clients are increasingly interested in a more dynamic asset allocation process centred around three distinct decisions.
• A wider spread of assets than is generally used.
• Combining those assets in a manner sympathetic to the client's aims.
• Being able to disinvest from any particular asset class completely.
Most private clients restrict their portfolios to equities, bonds and cash - with property held separately. However, alternative assets such as hedge funds, commodities and property are increasingly valuable as a source of diversification. For example, in 2002 while global equities fell by 27.3% - in local currencies - commodities rose by 19.3%. Indeed, equities were the only asset to fall in value during 2002:
Assets in 2002
Global equities -27.3%
UK bonds 9.4%
UK property 12.6%
Hedge funds 3.0%
The second stage of the process is to agree the strategic asset allocation because that gives the basic risk/reward profile of the portfolio. Understanding the way in which volatility impacts on portfolio risk is an essential part of this asset allocation process. Over the last 10 years for example, property and commodities have returned 10.9% and 11.2% per annum respectively. Would it have made any difference which of those two asset classes were held through the period? In terms of the return, no, but looking at property with a volatility of 1.2%, compared with 21.3% for commodities, then the answer is clearly yes. So, we must match the strategic asset allocation to the risk profile of the client. There is a further danger. That is, that the fund manager stays too close to the benchmark regardless of the outlook for each asset. That results in a failure to recognise that there are periods when high risk assets are more attractive than low risk assets. Perhaps it is more important to appreciate the converse of that statement - that there are times when high risk assets are unattractive even for young investors with a long-term horizon.
getting it right
It is rare to find an asset manager willing to move decisively between asset classes, without restriction, even where they might feel it is profitable to do so.
In summary, good asset allocation requires access to a wide range of ideally uncorrelated assets. This requires an asset allocation that closely reflects the risk profile of the client and a manager that allocates with conviction, even if it means, for example, being completely out of the chosen asset class at any one time.
The financial planner's value is in understanding a client's needs and matching them with the appropriate assets and the appropriate asset managers.
In considering the percentage to be allocated to each asset, the financial planner needs to revert to the client's investment objectives, time horizon and risk tolerance.
Good asset allocation requires access to a wide range of uncorrelated assets.
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