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.