Investment Management Firms
Why Investment Advisors & Wealth Management Firms Need Alternative Investments
Wealth management professionals such as pension funds and endowments generally avoid many of the psychological biases and pitfalls that are so common among individual investors and retail investment advisors. One way that wealth management firms can avoid human biases is by creating a written Investment Policy Statement (IPS) that lays out some ground rules in advance for investment advisors to make decisions. The IPS includes the objectives for their portfolio, their income distribution policy, a range of how much of the portfolio can be directed to various asset classes (asset allocation) and criteria for when, and at what valuations and conditions they will buy and sell. This written guideline is not developed during times of crisis. It is written when the investment advisor is thinking clearly and their employer, the wealth management firm, is able focus on the long-term. As a result, these institutions frequently achieve higher “Risk Adjusted” returns than individual investors. Every investment advisor would like higher returns. However, it may not be worth it, if your attempt to earn higher returns requires you to take more risk. The goal for most wealth management firms is to produce higher returns with the same (or preferably less) risk than they were taking previously. You cannot accurately compare the performance of two investment advisors or two wealth management firms simply by looking at past returns. You have to look at both returns and the risk taken to get those returns.
Let’s say an investor walks into our office and says that he earned 10% last year on his portfolio. Do I think that is a good return? The answer is… we don’t know. It depends on how much risk he took to get that return. 10% is a phenomenal return if his portfolio had the same risk as a T-bill (90 day debt issued by U.S. Gov’t). However, it’s not a very good return if he had the real possibility of losing half of his money.
So, we have established that the best wealth management firms use a written Investment Policy in order to guide their decisions and minimize behavioral biases. What else do the best investment advisors do differently? They use more alternative asset classes.
Alternative Asset Classes
Most retail investment advisors predominantly use traditional investments, which mean owning some combination of stocks, bonds and cash. It is very difficult to attain significantly higher risk adjusted returns by simply using these asset classes with a buy, hold and rebalance approach. In today’s economy, integrating alternative asset classes into your portfolio has never been more important.
What are alternative asset classes? Alternative investments include, but are not limited to: real estate, private equity, hedged equity, commodities, currencies, futures contracts, arbitrage, and absolute return.
Why Are Alternative Asset Classes So Important to Investment Advisors?
There are two reasons why alternative asset classes are so important to wealth management firms:
1. Provide growth during long-term cyclical bear markets (when markets move sideways for many years). Many individual investors design their portfolio looking in the rear view mirror. They feel that they can count on stocks to deliver double digit returns because they are relying on statistics extrapolated from 80+ years of market data. However, what happens when you experience a decade of zero returns in the stock market such as we saw from 1999 – 2009? It is even worse if the sideways market lasts for 17 years such as it did from 1966 – 1982, or 25 years from 1929 – 1954, or 18 years such as it did from 1906 – 1924 in the Dow Jones Industrial Average. (see chart below)
This scenario (a long-term sideways market) is even more devastating to an investment advisor if their client needs to take distributions from the portfolio like most retirees, endowments and pension funds. More and more wealth management firms and the clients they serve want consistent returns they can count on to provide systematic income in retirement. Endowments also need systematic income to support the operations of their institutions.
2. To Reduce Volatility – 30 years ago all you needed were stocks and bonds to have a diversified portfolio. However, it is important to understand that diversification does not mean that you simply hold many different investments. The key to diversification is to have a portfolio of investments that will not all decline at the same time. Therefore, you need some investments that go up when stocks and bonds are going down. Most major asset classes have become highly correlated over the last 30 years, meaning they now tend to move in the same direction. Investment advisors are relying on alternative asset classes to behave differently, in order to cushion downturns by going up (or even sideways) when the stock and bond markets have significant downturns.
The institutional approach to wealth management is not designed to hit “home run” returns of 20 – 30% Per Year (although years like that can occur). Instead it enables investment advisors and / or wealth management firms to focus on consistent compounding of more moderate gains to achieve greater results.
If you have questions or comments about wealth management or finding or evaluating an
investment advisor
in the Phoenix or Scottsdale area, please contact Jeremy Kisner,
Certified Financial Planner
(CFP) at (480) 272-7116. Mr. Kisner is the President of SureVest Capital Management, a financial planning and investment advisory firm and with two offices (Las Vegas, NV and Phoenix, AZ). The firm manages investment portfolios of $250,000 to more than $10 million.
Ebeling Heffernan Investment Management on NBT
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