What is success in wealth management? On first glance this seems to be a simple and even simplistic question, readily answered by “beating the market,” or “making more money,” or even “not losing money.”
Yet on patient review, these quick answers aren’t sufficient. Superior investment returns might not be accompanied by the liquidity an investor requires to meet spending needs. The pursuit of higher returns is furthermore often accompanied by volatility and risk that can lead to permanent impairment of capital. On the opposite extreme, a myopic focus on not losing money can ignore the damaging effects of inflation on purchasing power. Even with a reasonable expectation and pursuit of return, inattention to proper planning can allow taxes to offset investment results.
Success, it turns out, is not one thing, but a combination of things. We believe that successful wealth management requires a balanced and integrated approach to asset allocation, manager selection and wealth planning. In the pages that follow, we outline the fundamentals of these three activities, and explore how they interact.
Asset allocation is a phrase used more often than it is understood. A quick glance at the financial press would lead one to conclude that asset allocation is all about forecasting market action and adjusting a portfolio in anticipation of capturing returns or avoiding losses. This is a particularly easy temptation to fall into early in the year, as analysts up and down Wall Street establish return targets for the new year for a variety of asset classes. If history teaches us anything, it’s that we’re not actually very good students of history, as the reality of market performance rarely conforms to our expectations. It seems that the core job skill for most market analysts is the willingness to be often wrong, but never in doubt.
Yet investors can’t make decisions in a vacuum. A sober consideration and comparison of investment risk and return is warranted, but an overreliance on the imprecision of forecasting exposes an investor to the behavioral risks of overconfidence, which can be hazardous to one’s wealth. Furthermore, even if accurately determined, market action isn’t the most important input into a properly constructed asset allocation. A robust approach to asset allocation has far more to do with the needs of the individual investor than the returns on offer in capital markets.
Asset allocation is ultimately an exercise in balance sheet management. This is a common concept in the corporate world, and the notion has applicability at the individual and family level as well. Just as companies have assets and liabilities, so, too, do people. Some of these personal liabilities are easy to identify and quantify: mortgages, tuition payments, student loans and household budgets usually have dollar signs next to them, and it is relatively easy to determine how assets such as cash can be applied to fund those liabilities.
Yet many liabilities are more ambiguous, and for most families, the largest liabilities aren’t easy to quantify. When the mortgages are all paid off, the kids are out of school and on their own and credit cards become nothing more than convenience cards, qualifiable liabilities still linger.
One may decide to live a certain lifestyle, or in a particular location (or locations), dine in style, travel, collect or give money away to charity. All of this spending requires capital, and although these are not strictly liabilities in the technical sense, they are nonetheless volitional liabilities. To take the framework a step further, liabilities may even be aspirational in nature. You may live a happy and fulfilled life without spending a quarter of a million dollars for a ride into space with Richard Branson on Virgin Galactic, but wouldn’t it be nice if you could?
Understanding one’s personal balance sheet in this broader context, to include both quantifiable as well as qualifiable liabilities, implies that asset allocation is ultimately an exercise in arranging one’s assets so as to support those liabilities both now and into the future. A few fundamental implications arise from this observation.
First, asset allocation is not primarily a function of expected market action, or an effort to maximize portfolio returns versus an index. Effective balance sheet management requires the preservation and growth of wealth in absolute terms, not relative. After all, the S&P 500 Index1 doesn’t care about your spending needs.
Second, this concept of asset allocation requires a consideration of other dynamics in addition to investment return, to the degree that one’s liabilities impose other needs on the portfolio. For example, if the tuition bills are due next month, the balance sheet should provide not only enough assets, but also enough liquidity, to meet those deadlines. If the timing of future spending is uncertain, not only does liquidity rise in importance, but so, too, does the threat posed by price volatility. Selling depressed assets to meet unanticipated spending needs is not only unfortunate, but disruptive to a well-planned asset allocation.
Finally, this balance sheet model of asset allocation argues for a patient and strategic approach to the exercise. In theory, an investor’s strategic asset allocation shouldn’t change unless her liabilities do. That’s not to say that asset allocation should be set and then ignored. To the contrary, robust asset allocation requires a continual assessment, but that assessment relates more to shifts in spending, consumption, philanthropic and lifestyle needs of the investor than to anticipated changes in capital markets.
This is not to say that investors should spend undue time and energy attempting to quantify unquantifiable future costs. No one truly knows what the precise cost of living, healthcare, food and energy will be a decade from now, but a broad understanding of how those costs change over time will help inform the appropriate asset allocation.
Inflation poses a double threat to the goal of balancing assets and liabilities, by increasing the cost of future spending while diminishing the purchasing power of assets. This may seem to be a misplaced concern at present, as the headline Consumer Price Index (CPI) hasn’t actually warranted headlines for quite some time. Yet investors should not allow this to lull them into a false sense of security. Although we have lived in an environment of modest inflation for the past few years, there is no guarantee that this will continue to be the case in the future. Inflation has averaged a mere 2.6% over the past quarter century, but averaged 5.9% for the 25 years prior to that.
Furthermore, the relevant inflationary threat is not necessarily that captured by the Consumer Price Index, but the inflation rate specific to the investor’s pattern of spending. The CPI is an average, and an individual’s pattern of consumption might be subject to rates of inflation higher than the broad averages. The costs of health care and education, for example, typically rise at a faster pace than a broad basket of goods, as do the costs of travel and real estate maintenance. To the degree that an investor has this sort of spending on the liability side of his balance sheet, he should take less comfort in the apparent absence of inflationary pressure at the aggregate level.
More insidiously, even if today’s modest inflation is an accurate reflection of an individual investor’s consumption choices, the compounding of small numbers can wreak havoc on a balance sheet over time, as real liabilities rise with inflation and the real ability of assets to support those liabilities wanes. The miracle of compound interest is a well-recognized dynamic in financial markets, but that miracle can work against a poorly constructed portfolio. Consider that $1 million of financial assets, even at a modest inflation rate of 2%, loses close to 40% of its purchasing power over a 25-year period. At higher rates of inflation the damage to purchasing power is even more disastrous. If the expenses related to liabilities are rising while the real values of assets are falling, the challenge of managing an individual balance sheet becomes insurmountable.
This balance sheet approach to asset allocation is, by virtue of its subjective and qualitative nature, necessarily more of an art than a science. No one knows with precision what his or her spending or liquidity needs will be in a decade, or the degree to which inflation will have increased the cost of meeting those needs. The best laid plans have to adjust when they collide with the reality of lifestyle or health changes, shifting consumption preferences or inflation, but that is precisely what makes a consistent and repeatable approach to asset allocation so important. General Dwight Eisenhower, a man with some planning experience as Supreme Commander of the Allied Forces in Europe during World War II, once noted that, “In preparing for battle, I have always found that plans are useless, but planning is indispensable.” In other words, plans themselves are best understood as periodic expressions of an ongoing process.
Planning for asset allocation by taking into account the liability side of the balance sheet – whether those liabilities are quantifiable, volitional or aspirational – is an indispensable element of long-term investing success.
Having determined the right asset allocation to meet spending and liquidity needs while protecting against inflation, how, then, should an investor implement those various allocations? There is a growing trend to simplify the implementation question through the use of passive solutions such as index funds and exchange traded funds (ETFs). The Wall Street Journal reported at the beginning of the year that passively-managed stock funds enjoyed inflows of $244 billion during the first eleven months of 2014, while actively managed funds lost close to $13 billion. Investors, tired of higher fees and lackluster relative performance, have voted with their wallets in favor of passive management.
The argument against passive management is hard to make as we near the sixth year of a bull market. Why try to beat the market when successful managers are so hard to find, and when such attractive returns are on offer in index funds that carry expense ratios measured in mere handfuls of basis points? After all, an investor in an S&P 500 Index fund would have almost tripled her money since the market bottom in March 2009. The case for passive investing is easily made when the market is doing well, yet recall from the previous discussion on asset allocation that return is but one contributor (albeit an important one) to the ultimate objective of balancing assets and liabilities. An index investor signs up for the market’s returns, but also for the market’s volatility, thereby capturing 100% of both the upside and downside of market returns.
The stock market as measured by the S&P 500 has lost half or more of its value twice this century. From March 2000 through October 2002 the S&P index shed 49% of its price, surpassed by the 57% drop between October 2007 and March 2009. That price action stands as a stark reminder that indices are essentially price momentum strategies, and that price momentum works on both the upside and the downside. The S&P 500, like most indices and ETFs, is capitalization weighted, where capitalization is defined as the number of shares outstanding times the price of those shares. The larger the capitalization, the more shares an index fund needs to buy in order to mirror the index. As that buying demand exerts upward pressure on the price, index investors need to buy even more shares and the cycle continues. Yet this price momentum dynamic works on the downside as well. As prices fall, capitalization shrinks and demand for shares drops. This is admittedly a simplification of how prices and demand interact in the management of index funds, but nevertheless illustrates that there is an element of a price momentum strategy embedded in any capitalization weighted passive approach.
There is furthermore a behavioral dynamic at work that exacerbates the challenge of successfully implementing an asset allocation in passive strategies, and potentially even enhances the volatility experienced by an individual investor. Multiple studies have demonstrated that, whereas an index fund provides an index-like return, the average experience of an investor in an index fund is well below that. This apparent paradox is resolved by the field of behavioral finance, which has identified a number of cognitive biases that subconsciously lead us to make poor decisions about the timing of investments. In particular, the availability bias encourages us to place inordinate importance on readily available data, whether that data is truly informative or not. Headlines about plummeting markets can tempt us to sell at precisely the wrong time, whereas reports on new market highs can entice us to buy rather than be left behind in a bull market. We are, when all is said and done, a herding species, and we take comfort in company.
Yet, how can we argue with the Oracle of Omaha himself, the master of active management, who indicated in his 2013 report to shareholders that he would instruct the trustees of his wife’s trust to “put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 Index fund”? Warren Buffet answers that question in the same letter by noting how difficult it is to concentrate on one’s core competence as an investor while focusing on the durability of value rather than the appealing availability of price (there’s the availability bias again). That difficulty is exacerbated by the competing pressures imposed on professional managers in the investment management industry. As much as Warren Buffet knows about markets, he knows more about people.
Most institutional managers make more money by gathering assets than by generating long-term returns. For example, a mutual fund that grows rapidly can afford bigger paychecks, bonuses and earnings for the management company than a fund that remains small and focused on building a long-term track record. The time-honored way to attract assets is to marry a well-resourced marketing machine to a fund with a track record that is acceptable. If the fund performs in line with or even a little behind the market, the machine keeps running and profits continue to accrue. Yet if the fund underperforms sharply, the machine breaks down.
Here’s the rub. All successful investing involves an element of contrarianism, which in turn raises the risk of sharp underperformance over short periods of time. Investment decisions that aren’t contrary to conventional wisdom are, almost by definition, priced into the market. To make matters trickier, timing the turn in sentiment about a particular investment decision is more a function of luck, not skill.
Combining these two observations yields the insight that successful managers must be willing to look wrong, sometimes for extended periods of time. The incentive structures of most institutional managers are not designed to allow that to happen, and that’s why many active managers underperform. Most investment approaches are more about job preservation than wealth preservation.
Warren Buffett understands that successful active management requires an investor to tilt against those institutional incentive structures as well as some fundamental aspects of human nature. He hires active managers for Berkshire Hathaway with the temperament to invest in a contrarian way, and creates incentive structures for them that encourage the pursuit of long-term returns without regard for short-term volatility.
What does this imply about our search for truly excellent managers to fulfill our clients’ asset allocations? As we consider engaging investment managers on behalf of our Private Banking clients – whether proprietary solutions managed by BBH or third-party providers – we consider a few fundamental principles.
First, we look for investors with aligned incentive structures that encourage contrarian investing based on fundamental research. The best alignment of interests between managers and clients occurs when the managers are themselves clients of their own investment approach. We like to see that managers have a substantial portion of their own capital invested, as it focuses them on the pursuit of investment excellence rather than asset gathering. Investors who stand to make more money through the continued success of their investment approach – managers who eat their own cooking – are more likely to succeed in the long run.
Talented investment managers appreciate that there are necessarily constraints on how much capital can be invested through their approach before returns begin to suffer. Growth in assets is always, at some point, inimical to the continued efficacy of an investment approach, and a manager needs to understand and respect that constraint. The proof statement for this respect is the commitment to close a fund to new money once those capital constraints are approached, and we look for that proof statement in the managers to whom we allocate our clients’ capital. Once again, this willingness to turn away new assets flies in the face of the incentive structure that drives much of Wall Street, and requires that the manager’s own capital be at work in the fund.
Successful investment managers define risk in absolute rather than relative returns. If the ultimate objective of investing is to preserve and grow wealth in an effort to help the owners of that wealth meet their spending needs both now and into the future, what does that have to do with the return of the S&P 500? Investors should certainly hold their managers accountable for relative performance over time, but a comparison to an index should be an outcome, not an input. Trying to beat the S&P 500 by paying attention to it leads to overreliance on price and the temptation to predict or even chase trends in price, rather than adhering to a patient and long-term focus on value. Ironically, pursuing relative performance turns out to be the worst way to obtain it.
This different definition of risk is usually reflected in the makeup of portfolios. If risk is defined as the possibility of losing money, then the way to manage that risk is to know what you own very well, and own it at the right price. These are time consuming exercises, and naturally lead to more concentrated investment portfolios. To managers who see the world with these eyes, owning a more and more diversified portfolio of things you know less and less about is a curious way of managing risk. Once again, this is contrary to “received wisdom” for most institutional managers who define risk as deviation from the benchmark, and can’t deviate too far from that benchmark lest the asset gathering machine break down.
Risk is best managed not only through fundamental research, but also through the insistence on a margin of safety2 that arises from acquiring an asset at a discount to its intrinsic value3. Value is calculated differently from asset class to asset class, but the risk management principle is that there are no asset classes or investments that are intrinsically safe. Safety is a function of valuation, and the ultimate objective of preserving and growing wealth requires close attention to how price and value differ.
Performance is intentionally low on the list of attributes of talented managers, as one of the most difficult things in selecting an investment manager is to differentiate skill and luck through a consideration of performance alone. Performance, therefore, can’t stand on its own as a measure of manager skill, but must be interpreted in the context of investment philosophy, approach and implementation. The question to ask of a manager is not “how well did they perform,” but “did their performance reflect the approach they claim to take?” Consistency and repeatability or performance in context provides some comfort that the returns are driven by true talent.
Once again the availability bias raises its ugly head. It takes time and work to determine how managers are incentivized, how they define and manage risk, whether they appreciate and manage to capacity constraints, and the role that valuation plays in their investment approach. These are subjective value judgments that require a deep skill set of investment knowledge. It is, on the other hand, objective and easy to look at historical performance or count Morningstars. We are ultimately reminded of Albert Einstein’s observation that “Not everything that can be counted counts, and not everything that counts can be counted.”
Benjamin Franklin famously observed that the only two certainties in life are death and taxes. Both can be hazardous to your wealth unless you plan properly, and so appropriate planning forms an important third element in the pursuit of the preservation and growth of wealth. Poor planning (or no planning) can undermine even the most thoughtful asset allocation and manager selection. If asset allocation is an exercise in determining what investments one should hold to balance against present and future liabilities, and manager selection determines how those allocations are to be implemented, then wealth planning determines where they should be held. It is for this reason that much of wealth planning relates to asset location, or holding assets in the right structures in order to protect and grow them.
The challenge for investors is that wealth planning calls for serious introspection about future needs and desires. No one has a crystal ball, and the future is forever an unknowable place, but avoiding the wealth planning exercise for this reason is often the worst thing one can do, as it may needlessly expose accumulated wealth to a variety of hazards. Protecting against these threats requires the assistance of an attorney that can draft the documentation for appropriate structures, yet that initiative needs to be coordinated with asset allocation and manager selection. It is for this reason that we at Brown Brothers Harriman employ experienced former trust and estate attorneys as wealth planners, not as lawyers drafting documents, but as advisors working with our clients and their attorneys to ensure that asset allocation, manager selection and wealth planning are done in a collaborative and complementary way.
The paragraphs that follow are not intended to be a primer on how to implement wealth planning, but why, and provide examples of the role it plays in the ultimate pursuit of wealth preservation and growth.
Investors are generally familiar with the miracle of compounding returns – how allowing your money to keep working and earning additional returns on the returns that have already been earned and retained can lead to great wealth accumulation over time. That miracle is made even more miraculous if the wealth is sheltered and can grow without the drag of taxes. This is a familiar concept to anyone with an Individual Retirement Account (IRA) or company-sponsored 401k, but the protection can extend to other tax shelters as well. This is where thoughtful planning for the future comes into play, though funds invested this way usually can’t be accessed until a certain age without paying a penalty, thereby negating whatever benefit was originally envisioned.
Good asset location intersects with asset allocation, as individual circumstances may make it more appropriate to hold certain asset classes in different vehicles. If, for the sake of easy illustration, an investor’s desired asset allocation was 70% equity and 30% fixed income, that doesn’t imply that this same allocation should be reflected in every account she holds. Her preferences or needs for liquidity, return and when those returns are necessary might lead her to hold equities in a certain account and fixed income in another. Although those individual accounts would then look unbalanced, asset allocation applies to the investor, not necessarily to each account within an investor’s overall portfolio.
Proper wealth planning can also help to protect assets against the claims of creditors. We unfortunately live in a litigious society, where plaintiffs and the trial bar do not hesitate to pursue financial compensation from wealthy individuals for damages, whether perceived or real. Appropriate trust structures can not only protect assets in the event of a claim, but even make those claims less likely if it becomes obvious that assets are well protected. In other words, careful wealth planning can act as a sort of insurance policy.
Asset protection is critical in the specific case of a family business, where divorce can lead to claims on part of a business and, in the worst case, lead to the forced sale of a business to satisfy a settlement. Pre-nuptial agreements are a common and effective way of dealing with this issue, and other structures to hold family businesses can provide protection against this and other risks as well. Again, it is not our intent in these few passages to delve into the mechanics of these structures, but merely to illustrate their efficacy in helping to protect and grow a family’s wealth.
Wealth planning is perhaps most effective in making sure that a family’s assets transition from one generation to the next. The estate tax exemption for 2015 stands at $5.43 million per individual, or $10.86 million per couple, so estates below those values needn’t worry about the impact of estate taxes on their heirs, at least until the tax laws change again. Yet families are often worth more than they realize, particularly when the family wealth is held in the form of hard-to-value real estate or a private business. All assets, whether financial or real, are valued upon the death of an individual, and estate taxes are then applied to values above the exemption amount. Again, in the worst case scenario, illiquid assets might have to be sold on short notice to meet an estate tax bill unless plans are implemented well in advance. In addition to the federal estate tax, nineteen states (plus the District of Columbia) impose their own estate taxes, so proper planning should take that into account as well.
Estate and gift tax law provide numerous opportunities for business owners who want to retain control of a business in the family across generations. Gradually gifting or even selling minority shares of a business to the next generation can result in a significant reduction in estate taxes. As is true with most aspects of the law, the devil is in the details, and investors should work with a wealth planner as well as an attorney to make sure that the details are all in order.
Wealth planning is necessarily an iterative exercise. The legal framework changes from time to time, as do individual circumstances. Plans can’t be made and then ignored. Just as you get a regular physical checkup, so, too, should you get a regular fiscal checkup by reviewing your wealth plan and the documents associated with it. The price of financial liberty is eternal vigilance, and when integrated with asset allocation and manager selection, robust wealth planning provides that vigilance.
Successful wealth management is an exercise in balance and integration. Appropriate asset allocation is driven by an investor’s liabilities, whether quantifiable or aspirational, and by the return and liquidity needs associated with those liabilities. Careful manager selection enhances the likelihood of investing success over time through disciplined risk management and identification of value. Wealth planning ensures that those investments are structured so that investment returns are allowed to compound, and so that assets are protected and transitioned to their ultimate end use.
These are not independent pursuits: each informs, and is informed by, the other. Observations gleaned from investment managers often provide insight into a discussion on asset allocation, and the specific needs of investors can similarly prompt the selection of appropriate managers. Liquidity and spending needs drive a major part of the wealth planning process, while at the same time influencing asset allocation and manager selection. An investor intent on preserving and growing her wealth needs to engage in all three of these activities in an integrated way in order to do so.
This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries ("BBH") to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area ("EEA"), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries.
© Brown Brothers Harriman & Co. 2015. All rights reserved. 2015.
1 S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index is not available for direct investment.
2 Margin of safety: When a security meets our investment criteria and is trading at a meaningful discount between its market price and our estimate of intrinsic value.
3 Intrinsic value: What one estimates to be the value of a security based on analysis of both tangible and intangible factors.