Many private wealth managers seek to outsource the management of client investment portfolios. Investors with $10 million or more have new investment expectations, and outside portfolio managers must have certain capabilities to keep up with these needs. The high-net-worth investor requires more portfolio customization than ever before.
Separate account structure or "a la carte" menu formats are widely available to clients outside the high-net-worth category and no longer competitive.

When competing for clients, the successful wealth advisor will offer sophisticated portfolio management services that are truly tailor-made for each client. This article explains how a wealth manager can identify investment managers who offer state-of-the-art portfolio management for high-net-worth clients.

Outsourcing And Its Importance
Private wealth managers have always been interested in outsourcing the management of client investment portfolios. Even though most usually manage some of their clients' investment assets themselves, they may not have adequate staff for handling all types of asset classes. A firm with a 30-year track record of managing traditional long-only equities and bonds in a balanced strategy, for instance, may outsource an emerging market equity sleeve to a manager with an established track record, substantial infrastructure and significant assets under management in the strategy. Or they may outsource the management of a private equity strategy because of the specialized expertise and research that is required. Outsourcing essentially extends the staff for private wealth managers who prefer not to add their own full-time resources to build out a strategy.

Market research suggests that many private wealth managers outsourced at least some of their asset management strategies over the last year. Since private wealth managers keep searching for new ways to gain high-net-worth market share, the outsourcing trend should continue.

Driving The Outsourcing Demand
As high-net-worth clients become more educated about their portfolios and compare notes among their peers, most will become familiar with sophisticated management models that have gained popularity. In the past, the state of the art for wealthy clients' investment portfolios was simply separate account management, in which a financial advisor assembled a diversified portfolio handled by a variety of professional investment managers. With the advent of broker-sponsored "wrap platforms," separate account management migrated to investors who had less than those in the high-net-worth category, making such investment practice common. The need for better quality services for investors in all wealth categories has caused a "downward migration" of high-end services. This movement is a seismic shift, like offering first-class services to coach-class prospects. All now enjoy services that were formerly available only to those in the next higher category of wealth.

From the private wealth manager's perspective, it has been much easier to compete by moving down in client size rather than up. The ultra-high-net-worth space is a crowded, highly desirable market category. Gaining any market share is challenging. By offering high-net-worth-like services to those with smaller accounts, private wealth managers have more easily gained clients in the battle to win more market share.

Private Wealth Managers Outsource Tailored Portfolios
Lean staffing at most wealth offices limits the areas of quality concentration. Even the largest private wealth managers need to outsource portions of their portfolios, because the range of expertise is simply not available at one firm. Even if wealth advisors strategically decide to add expertise in house, unless they buy an established manager with a five-year track record, the office will have to incubate a funded portfolio (not a cashless "model") for about five years before employing the strategy in an asset allocation scheme. At smaller staffed wealth advisors, most principals wear many hats, and it is virtually impossible to add intensive investment management to the mix. Outsourcing is an obvious solution.

The Rise Of The "Tailored Portfolio"
If a coach-class flyer can now travel like a first-class client, what is left to attract a first-class prospect? The answer is a true custom portfolio, the equivalent of Air Force One accommodations. The high-net-worth base has now reached upward to the models that once were uniquely employed by the world's wealthiest investors. These custom portfolios offer structures not found in the lower minimum wrap models. The goal of these state-of-the-art strategies is to offer better risk-adjusted returns against very client-specific circumstances and constraints. These investment structures could be called "tailored portfolios."

Tailored portfolios have surpassed the core-satellite/SMA approach to managing accounts and are truly the state of the art for high-net-worth investors with assets of $10 million or more. The core-satellite/SMA portfolio used to be enough to engage most sophisticated clients. Basic core investments such as U.S. equities and fixed-income strategies were supplemented by active managers of more esoteric strategies, such as emerging market, high yield, private equity, hedge funds, etc. Private wealth managers often designed the mix of asset classes to match the risk profiles of each client, but it was difficult to accommodate client-specific idiosyncrasies within the limitations of the model. Enter the tailored portfolio approach.

Most "new money" prefers the tailored approach because it better fits their circumstances. Entrepreneurship, scientific discovery and business ventures are more complicated sources of wealth in the 21st century. These new generations of wealthy clients usually present more financial complexities that often don't fit the core-satellite formalism. Their estates require more customization than ever before.

Varieties Of Tailored Portfolios
It is difficult to define tailored portfolios in general terms because almost every high-net-worth client's estate and financial circumstances are different. Not long ago, one would assume a "custom portfolio" would exhibit simple constraints, like a socially responsible portfolio does. But compared with the complicated constraints clients have today, that example seems extremely simple. There are many circumstances where an à la carte menu of investment strategies simply doesn't satisfy more complex portfolio appetites.

Here are some examples of portfolios that attempt a more personal approach:

The liability-matched portfolio. This is an excellent and popular example of what can be done when a client's personal financial circumstances are unique and require an exclusive solution to meet a schedule of future liabilities already known in the present. For instance, a client may be involved in a business arrangement where the profits of certain investments will be paid out in equal installments. Or they might even be made in a series of "lumpy" payouts on an irregular schedule. In order to effectively plan for such payments and their associated tax liabilities, the private wealth manager may suggest a tailored portfolio of fixed-income securities that will mature in time to meet required tax liabilities. Unlike a standard "laddered" bond portfolio where an equal percentage of the portfolio matures every year, a tailored portfolio has "uneven rungs"-the maturity dates need not be evenly spaced. It also has credit quality highly tailored to the client (in a mix of high-yield and investment-grade bonds) in order to match both his or her liability schedule and tolerance for investment risk.

Other variables that enter into the mix involve decisions about using municipal tax-exempt bonds, taxable corporates, Treasurys or some combination of these as the building blocks for the portfolio. Such decisions certainly require fixed-income expertise that extends well beyond "one size fits all." The right outside manager will work with the wealth manager and the client to ensure the best portfolio is constructed, taking all these details into account.

The all-corporate-bond, custom quality and maturity portfolio. When clients become apprehensive about the capital markets, many don't want to invest in stocks at all. Furthermore, clients that know even a little about bond markets tend to fear interest rate increases and bond price decreases, but are frustrated with the low rates that "safer" money markets and certificates of deposit (CDs) earn. Other clients with careers in very risky investment businesses like leveraged buyout firms don't wish to subject their own partner's distribution funds to general market risk. These latter clients often "barbell" their worth by having their wealth investments split between their risky professional investments and pure cash savings accounts. The solution for such clients is an all-corporate bond portfolio that has short maturity (one to five years) and high quality (investment-grade, rated "A" and above). While many individuals would not invest in a generic bond SMA, they appreciate a compromise that allows them to earn more income than CDs would with a small extension of credit risk-especially if they will not require the funds for several years (the maximum maturity of the bonds being five years). This structure produces an excellent stream of income for an investor who is seeking higher rates but doesn't want to take on extensive investment risk. If the bonds in the portfolio are held to maturity, then the client will receive par for each bond that matures (assuming no defaults), which should offset the client's anxiety about daily price volatility. Furthermore, such a portfolio can be "custom fitted" for individuals: The credit quality and maturity blend can be changed to accommodate most demands.

The all-corporate portfolio is quite popular when investors are defensive, so there is a seasonality in this strategy that drives its current popularity. However, for clients (such as the leveraged buyout executive) who wish to barbell their portfolios all the time, there is a constant need for this structure that is not market-dependent.

Tax-exempt portfolio conversions across different states. One can imagine circumstances where a successful client has built a computer technology business in California and has decided to retire elsewhere-for example, Florida. Often, such clients have compiled a large amount of their liquid worth in a state tax-exempt portfolio and are interested in preserving the tax-favored nature of their fund as they transfer to the state where they are retiring. This is not as easy as it sounds. For example, if the client holds mutual funds, converting a California tax-exempt mutual fund to its Florida counterpart would require selling one fund for another without regard for the individual's personal tax situation, including the gain-loss positioning. This is no longer acceptable, since clients expect a higher level of treatment and sophistication. They would prefer to be invested in a tailored muni portfolio-a separate account that holds specific municipals laddered in different maturities. In a California-Florida transfer, for example, a separate account would allow the portfolio manager to rank each security in order of sale sequence, which would likely take into account liquidity, credit risk and gain/loss computations. Because the liquidity of some short maturity munis may be weak, forcing a bid could produce a payout that's less than par for the client. Simply holding the short maturity California munis and then buying Florida munis with the proceeds could be a solution. By holding to maturity, a client would most likely receive the full par proceeds with no market discount. That way, the client would not see any capital losses. But all cases are different depending on the circumstances. Even if a client is not yet thinking about retirement in another state, portfolio managers should have that conversation well ahead of the event in order to integrate the conversion possibility into the management process. That could help optimize returns for the client during the conversion phase.

Custom-weighted portfolios. When a client engages a new relationship and charges the private wealth manager to manage the investments, often the assets are transferred "in kind," in other words, legacy holdings. While the mechanics of the transfer process are usually simple, philosophical differences about converting the assets can be the very first compatibility test between client and advisor. Large overweight positions in a retired CEO's company stock, family gift stocks, etc., are usually accompanied by an unexpected emotional connection to many of the securities. This sensitive complexity can stress the client/private wealth manager relationship and must clearly be understood in order to manage the investment portfolio fairly from both perspectives. The tailored portfolio should acknowledge the client's sensitivities without compromising the overall investment goals set by the portfolio manager. For example, a client may be a retired executive from a large public company and have a considerable portion of liquid assets in the stock of that company. An outside portfolio manager that does not tailor the strategy will offer very limited solutions: sell the stock immediately, sell over time or hold the stock in a "carve-out" account that is not included in performance calculations for the client. A tailored portfolio manager will offer more creative solutions like writing call options against the stock to take risk off the portfolio, or other strategies that treat the overweight elephant in the room holistically with all the assets rather than ring-fenced away from the client's net worth. Instead of seeking indemnification for the risk, some managers underweight the entire sector against the overweight stock so that the portfolio will have a neutral sector weight overall. There are numerous other approaches, but the point is that not all managers can be that flexible. When competing for high-net-worth market share, inflexibility impedes success.

Searching For A Tailored Portfolio Manager
Suppose a private wealth manager has decided that tailored portfolios benefit the client as well as the firm. How does one identify and select outsourced managers that can do the job? Identifying an investment manager that will truly manage custom structured accounts is challenging work beyond the basic due diligence conducted for standard managers. The best practice assembles a selection committee that identifies and evaluates managers using a set of analytical steps. In order of difficulty, there are three main steps in the process: identifying basic investment skills, assessing the operational risk of the prospective firms and verifying that the firm manages true tailored portfolios and not mere model portfolios.

Step One: Identify Basic Investment Skills:
A good starting point identifies strong managers that have public performance records based on model accounts. Work such as screening databases, interviewing prospects, checking references and verifying composite performance is standard. But be aware that the composite performance won't include the tailored portfolio performance, because custom portfolios by their nature are unique and cannot be grouped together based on similarity. Searching databases is not an ideal way to begin, but excellent managers of composite portfolios may also offer tailored portfolios with the same management skills.

Step Two: Assessing Operational Firm Risk
Once strong managers have been identified, private wealth managers should personally interview the prospects to evaluate the firms' operational risks. A due diligence checklist should identify custodial agreements, track records, the compliance history and the tenure of the investment staff as crucial elements to vet before proceeding to the last step.

Step Three: Verifying A "True Tailor"
The prior steps are simple compared with this one. The attributes of tailored portfolios are not easy to determine and take considerable time to verify. Be wary of any managers that broadly state, "Yes, we certainly construct custom portfolios" when asked the question. A private wealth manager can "test" the true independence/customization of an investment manager by asking a series of simple questions such as:
Who is your most complicated client?
How many of your clients require above-average structuring time with their portfolios?
What is your definition of an overweight stock?

By asking simple questions like these, a private wealth manager can ascertain whether the manager actually tailors accounts to meet the subjective needs of clients. For example, suppose a client needs a portfolio with carved-out overweight stock positions. The answer to the last question above  will disclose the manager's ability to accommodate the client's needs. If the answer is, "No portfolio holds any stock greater than 5% of the total portfolio," they have inadvertently disclosed that they would not tailor that client's account. In addition, the "case study" questioning can be revealing. Presenting a fictional client's circumstances of liability payments to a prospective manager should lead to the liability-matched portfolio. If not, then the manager is not willing to customize.

Future Outsourcing Trends
Expect highly customized outsourcing to continue, because it solves many problems. It offers the private wealth manager access to specialized managers at reasonable costs, and keeps them in the battle for increasing market share by offering the most up-to-date models for asset allocation. From the clients' perspective, outsourcing offers access to non-traditional managers through true custom structured investment management. And if the managers are chosen correctly, clients will have access to those investment managers for specific, personalized solutions to their investment challenges.    

Peter C. Andersen is chief investment officer of Congress Wealth Management Company in Boston.