"When you start (investment guideline review) conversations, it's always good to rewind and start with a summary of the client's overall situation," he says. "Once this has been reestablished ... rebalancing and asset allocation should be discussed. At this point discussions of tax loss harvesting might make sense, given what gains may have been realized in the client's overall portfolio. Historically, we have seen that focusing on taxes first has led to potential loss in investment return."
According to Coleman, there are three areas to keep an eye on when writing any investment policy statement. First, the IPS should be very clear and easy to understand. The client should have a copy of it and should be able to pull it out, read it and understand it; sometimes people get a little too "lawyerly" and try to fluff it up a bit. Second, make sure there is a section that deals with investment objectives. The objectives should be quantified, articulated well and should be achievable. There is a responsibility on the part of advisors to manage clients' expectations and objectives, to accommodate the environment of the capital markets. Third, the flexibility of the client's money manager should not be unduly restricted. The client's desires should be incorporated into the management of the portfolio, but the manager also should have the opportunity to participate.
There should be a section outlining the responsibilities of the client, of the advisor, of the money manager, the custodian-everyone who has a role regarding the portfolio. As an example, for a fiduciary, this could entail knowing whether the trust involved was for a minor child who is a paraplegic with a $20 million insurance settlement, the investment of which is to be managed to meet income requirements for the life of that child. Or the funds could be for a private foundation with assets designated for funding public television. For an advisor working with a high-net-worth individual, the same care should be applied in understanding the objectives for the designated pool of assets and within what context those assets are to be invested.
Another pitfall is the creation of an IPS in a vacuum. Many advisors make the mistake of focusing only on the pool of assets that have been placed in their care. For example, a more comprehensive IPS may need to be written to govern an entire estate. Individual guidelines and objectives can then be cited within the umbrella IPS to govern each separate set of assets. Each money manager should receive a copy of the part of the IPS that pertains to his or her mandate and, in some cases, should receive a specific set of investment guidelines. This practice can vary from manager to manager and from asset class to asset class. Again, it all goes back to DeWees' tenet of working on a case-by-case basis.
A Few Advantages
"I've always felt (rebalancing) should be a combination of rearview mirror and forward looking," Coleman adds. Going through what he calls an "upside/downside analysis," and showing how the equity markets performed in various types of environments, gives the client a frame of reference. Next, it's advantageous for the advisor to draw down whatever resources are available to employ some sort of forward-looking analysis and say, "OK, we seem to be entering into such and such environment. The election (or some other event) is coming up, so we may want to position the portfolio this way in the short term from a strategic perspective." Coleman further explains that such events may affect the timing in creating a new portfolio or the selection of style managers.
Rebalancing for the sake of rebalancing is not favored by any of the experts interviewed for this article. For tax-favored accounts, the DeWees Investment Consulting Group concentrates on its capital markets outlook as primary criteria for rebalancing. "Ours is a more dynamic type of rebalancing. For our taxable clients, we consider our capital markets outlook first, then overlay tax sensitivity." In some years, there may be taxable events that need to be considered. Liability in one year may be lessened by taking more losses than are actually needed. In other years, gains may need to be harvested in order to accelerate some of the tax loss carry-forward. "That's the beauty of separately managed accounts, for example-you can 'lift the hood' and drive tax harvest one way or the other," he adds.
Pagliara points out that the tax considerations should be outlined within the IPS and if outside managers are being used, control over taxable events will be minimal. "The manager will be responsible for that under their discretion and authority." He further points out that rebalancing guidelines should also be found in a well-written IPS. "The whole purpose of rebalancing is to minimize uncompensated risk. That risk occurs when concentrations are built up in specific asset classes; rebalancing diminishes that risk."
There is much more to be considered regarding end-of-year client account activities, and volumes have been written about them. But just the two vital processes of rebalancing and revisiting the investment policy statement will greatly help advisors better understand their clients, and will assist them in appropriately allocating their assets for the greatest chance of achieving their financial goals. Operating within the context of IPS guidelines helps keep those goals on track.
