Editor’s Note: The following is an excerpt from Curtis’s book, The Stewardship of Wealth: Successful Private Wealth Management for Investors and Their Advisors, published by Wiley.
While most institutional portfolios have similar objectives, the objectives for family portfolios can be radically different. It is therefore crucially important that families and their advisors discuss the family’s goals, dreams, fears and so on so that the objectives of the portfolio will accurately reflect the family’s wishes.
At the end of the day, for the bulk of their portfolios, most families will want to focus more on the return of their capital than the return on their capital. It’s not that high returns are unimportant—it’s that private capital is irreplaceable. Most families that have accumulated a great deal of liquid wealth are no longer in the wealth-producing phase of their family history. Indeed, the reason they have the liquid wealth is that they have sold the family business.
Contrast this with institutional capital. If a university endowment experiences dismal returns and its capital has shrunk relative to inflation, the university will simply gear up its advancement office and mount a capital campaign. If a pension plan performs poorly, the sponsor company will simply be required to inject capital into the plan. But if a family’s wealth shrinks or disappears, it can’t be replaced—it’s gone forever.
This is what people mean when they say that family investors tend to focus on “capital preservation,” or when they say that institutional investors are “relative return-oriented” while family investors are “absolute return-oriented.” If the equity markets are down 30% and an institution’s equity portfolio is down 28%, the institution has outperformed relative to the indices and is, at least theoretically, satisfied. But a family whose equity portfolio is down 28% is unlikely to be satisfied, theoretically or otherwise.
Note, also, that unlike institutions, families often hold their wealth in radically different “buckets” that may have very different objectives. To take a simple example, imagine a family whose patriarch and matriarch have plenty of wealth to satisfy their needs over their lifetimes. They may wish to own a relatively low-risk portfolio. On the other hand, that same family may have established a generation-skipping trust (GST) that has no spending demands on it and which is intended to benefit generations that haven’t yet even been born. The portfolio for the GST may take on much higher risk.
Because the process of understanding a family and its objectives is so crucial, it can take many months and many conversations to get it right. Advisors who rush into the job of designing a portfolio are likely to find that they have incorrectly understood the family’s needs and/or that the family has misstated those needs. Getting this process right takes time.
“Current” Vs. “Growth” Claims
One useful way of thinking about the initial steps of portfolio design is to ensure that the portfolio is built to satisfy—on a prudent basis—both current and future claims on it.
Current claims include the family’s spending needs, such as taxes, plus any additional lifestyle needs, such as travel, philanthropy and so on. Future claims (or “growth” claims) require that the portfolio will maintain the family’s purchasing power (net of inflation) over time, net of taxes and all fees and costs, and will also likely include the family’s desire to enhance its financial status on a net-net basis.
Looked at in this way, we can see that the family is exposed to three primary risks. The first and most urgent risk is that the family could fail to meet its spending needs. The second risk is that the family’s lifestyle might not be maintained: Even if their income stays the same, its purchasing power will decline in the face of inflation. Finally, the family could overcome those two risks but still fail to enhance its wealth across the generations. This last risk is the most difficult to overcome, not least because it is decidedly the case that families tend to compound faster than capital.
Matching Assets To Risk
Risk No. 1—ensuring that the family can meet its current spending needs—requires that the family own an appropriate amount of “capital preservation” or “protective” assets, assets that will throw off income and tend to hold their value even in a broad and deep financial crisis. These assets will include cash, Treasury securities, TIPS and, as appropriate, portfolio hedges executed through puts, calls and collars. Extremely safe municipal bonds might also fall into this category, although most municipal securities won’t qualify, since in a deep financial crisis, cities and states will find their income impaired. And, unlike the federal government, they can’t print money.
Risk No. 2—maintaining the family’s lifestyle net of inflation over time—requires that the family own an appropriate amount of “market” or “growth” assets. These assets include global equities, bonds other than Treasurys, cash that is held for optionality reasons, hedge funds of funds, diversified real assets (including commodities) and hedge funds.
Risk No. 3—the serious challenge of increasing a family’s wealth over time net of all costs—requires the family to invest in “aspirational” assets, which include venture capital, buyouts, individual hedge funds, distressed illiquid investments and concentrated real estate.
Investment assets generally offer return characteristics that are consistent with the risks assumed. Thus, cash is a very safe investment, but it returns less than inflation (after tax) over time. Venture capital returns can be very high, but the risk associated with venture investments is extreme. Thus, the more capital preservation assets we put in a family’s portfolio, the lower the overall portfolio return will likely be. The more aspiration assets we include in the portfolio, the higher the risk will be.
It is at this point that modeling becomes important. In effect, the optimizer is told what percentage of “income” and “aspirational” assets to hold and then it simply optimizes for the “growth” of the portfolio. By specifying the income assets, we ensure that the family’s current spending needs can be met. By specifying the aspirational assets, we at least give the family some hope for growing its wealth dynastically. The optimizer will specify the best combination of growth assets that will keep the family capital growing with inflation.
Traditional Asset Allocation
Financial advisors have traditionally begun the asset allocation process by assuming that there is a regular relationship between risk and return. For example, we would start with cash (the lowest-risk, lowest-return asset), then add an increment to compensate for the risk of buying the next riskiest asset and so on. (See Figure 1.)
This approach is accurate enough in a general way: Over very long periods, cash will be the least risky and the lowest return asset, while equities will return much more, but with substantially more risk. But no one knows what the value of the incremental premiums should be. Even the equity risk premium, probably the most important source of return, is unknowable. Scholars have debated the value of that premium, and their estimates for it range from 0% to 7%.
The estimates get more uncertain as we go out along the risk spectrum. Since all the estimates are linked, errors can compound as we go along. Certainly, 30 years ago, no one was predicting that bonds would outperform stocks, but that is what has happened. Maybe 30 years is simply too short a time period to make such a calculation, but note that three decades is longer than the typical investment lifetime for a member of a wealthy family.
Modern Asset Allocation
These flaws in traditional asset allocation are among the reasons many advisors have moved to an approach championed by Fischer Black and Robert Litterman, known as the Black-Litterman model. Black-Litterman is an alternative method for estimating the inputs needed for portfolio optimization. Instead of estimating forward-looking risks, returns and correlations, Black-Litterman relies on equilibrium models to determine the inputs.
Thus, Black-Litterman lets the markets tell us what returns are, creating a market equilibrium portfolio using Capital Asset Pricing Model (CAPM) techniques. Black-Litterman presupposes that if everyone in the market had the same views about valuations, the demand for various assets would equal their supply.
Thus, global market capitalizations tell us what we need to know about returns, except for the process of applying our own views to that mix. As Black and Litterman put it in their original paper, “Our approach allows us to generate optimal portfolios that start at a set of neutral weights and then tilt in the direction of the investor’s views.”
Whether stocks are cheap or expensive can’t be known in advance, but an investor or his or her advisor will likely have an opinion, and that opinion, using the Black-Litterman approach, will drive the stock allocation in the investor’s asset allocation strategy.
Satisfying Portfolio Claims Prudently
Recall that I said that claims against the portfolio must be satisfied on a prudent basis. What I am thinking about is that the path of a portfolio’s returns matters a great deal. Imagine a 6-foot-tall non-swimmer who is determined to cross a pond he knows to have an average depth of three feet. The critical question for our non-swimmer isn’t the average depth of the pool, but the deepest depth. If the pond is one hundred feet across, and there is a 30-foot stretch that is 15 feet deep, our non-swimmer is doomed.
A family can also be doomed even if the long-term average return on its portfolio is satisfactory, because there could be a very bad stretch in the markets that drives the portfolio value and the family’s income below critical limits. Thus, a portfolio can end up, many years in the future, achieving the family’s long-term return objectives, but the family (or the portfolio) won’t be around to see it. The portfolio ultimately achieved its goal, but it was a failed portfolio because along the way it allowed the family’s wealth to fall below the minimum level that enabled it to live the way it wished to live.
Gregory Curtis is the founder and chairman of Greycourt & Co., a wealth advisor serving high-net-worth families and endowments.
Excerpted with permission of the publisher, Wiley, from The Stewardship of Wealth: Successful Private Wealth Management for Investors and Their Advisors by Gregory Curtis. Copyright © 2013 by Gregory Curtis. All rights reserved.
