Wealth managers need institutional mindset

Advisors serving the private wealth market should consider focusing on the client’s liabilities, rather than the traditional approach of focusing on assets first, according to a French investment thinktank.

A research report from EDHEC-Risk Institute, entitled Asset Liability Management in Private Wealth Management, advocates for the adoption of institutional-style matching of assets to liabilities as a means of reducing risk.

Just as pension fund managers aim to earn returns that will ensure their clients can meet their future liabilities — retirement income payments of the pension members — private wealth managers need to determine what their clients plan to spend their money on in the future, and match their investment portfolio to the future cost of these goals.

Such an approach attempts to hedge risks on the liability side of retirement, such as the impact of inflation on projected spending plans, rather than simply amassing as large an asset base as possible.

“Taking an Asset Liability Management (ALM) approach leads to defining risk and return relative to a liability portfolio, a critical improvement on asset-only asset allocation models that fail to account for the presence of investment and/or consumption goals and objectives, such as preparing for retirement or for a real estate acquisition,” the report says.

Once the liability hedging strategy is in place, it will drive asset allocation. Say, for example, the client intends to buy a piece of real estate five years down the road. The traditional asset-based approach to maintain capital for this purchase might use a five-year zero-coupon government bond.

But this would not be the “perfectly safe” investment, according to the authors of the study.. If property prices increase 35% over the five-year investment horizon, the zero-coupon bond would be insufficient to cover the cost of the real estate asset.

A better choice would be to stash the capital in an investment that is perfectly correlated to the real estate market in question. Even if real estate values decline and drag the investment lower as well, the client will still be in a position to buy the property.

“It is not the performance of a particular fund or that of a given asset class that will be the determinant in the ability to meet a private investor’s expectations,” the report says. “What will prove decisive is the ability to design an asset allocation program that depends on the particular risks to which the investor is exposed.”

Constructing a liability portfolio provides the wealth manager with a new benchmark. Rather than assessing performance against an arbitrary stock, bond or balanced index, the portfolio’s performance is judged against the actual needs of the client.

“This is a critical improvement on asset-only asset allocation models, which fail to recognizerecognise that changes to asset values must be analysed in comparison to changes in liability values,” the authors of the report note. “In other words, private investors are not seeking terminal wealth per se so much as they are seeking terminal wealth whose purchasing power enables them to achieve such goals as preparing for retirement or buying property.”

Perhaps, those that are best positioned to take advantage of the ALM model are private bankers, many of whom often promote the model implicitly, the authors say. But basing investment choices on future liabilities should be explicit, and could demonstrate a better understanding of the client’s needs.

Read the full report.

(09/28/09)