For many investors, the start of 2018 seemed to promise a year of smooth sailing for their investment portfolios. Stocks were surging, records were breaking, companies were hiring, and there, on the horizon, one could just begin to make out the shape of long-promised tax reform. Now, not even six months into the year, volatility has returned to the markets and it's tougher for investors to navigate these waters, especially when it comes to determining their asset allocation strategy. But it's not just volatility that has many investors confused. Practically anywhere they're turning for financial news or insights, they're likely seeing pundits praising passive strategies, while someone else is saying there's no alpha without an active portfolio. Unfortunately for financial advisors, uncertainty doesn't necessarily bring in more business, but it does bring in clients whose very skittishness may set them on a course toward portfolio self-harm. That's why now is the best time to talk to your clients about the design of their portfolios and also check to see if their needs or risk tolerances have changed and if a revised investment objective is warranted. Market volatility and uncertainty bring the behavioral aspects of risk tolerance in to focus and clients may discover their feelings about risk are not what they had expected.
To help clients better understand the structure of their portfolio as the debate over passive versus active shifts into a period of greater market volatility, there's a few things that financial advisors can do help their clients understand the investment strategies and portfolio tactics that are right for their specific needs.
First, help your client lean into their risk tolerance. While there's no need to play to anyone's fear or have your client swept up in the drama of micro-fluctuations in the market, it is a good time to have your client say in their own words what their tolerance for risk is. Listen to them and try to get a sense of what may have changed about their risk tolerance and why. Remind them that investment portfolios can be structured with risk in mind, while keeping them on a path to successfully meet their goals.
Second, help your client understand that when it comes to the active versus passive debate, they don’t have to choose sides. Instead, they can choose products that meet their needs and will help them achieve their goals. Many affluent and high-net-worth investors might feel as if they're forced to "come down" on whether they need a passive investment vehicle or active management that will let them beat whatever benchmark they've focused on. It's up to advisors to let these clients know that their portfolios need not be weighted in any one of these directions. Access to a wide array of managers and management styles is a benefit provided by a well-constructed portfolio. It's important to strike a balance of active and passive management in a portfolio to help keep costs down while still gaining exposure to the benefits of active managers. Over-exposure to active management increases the implementation cost of an investment strategy and can wipe out its benefits. Tactically rebalancing a portfolio to take advantage of cyclical market opportunities can be an additional source of alpha without incurring the cost of active managers.
Third, don't be afraid to talk fees. Remind your client that it's not just the portfolio management fee that they need to consider. Walk them through the underlying fees in their portfolio so that they can truly see the real costs associated with a specific investment strategy or product. Even more importantly, take the time to discuss your approach to portfolio selection. Show them how you really bring fee consciousness into your recommendations.
Finally, remind them to keep their balance. Balance is critical in a portfolio. Risk, reward. Active, passive. And perhaps most importantly, the strategic and tactical must work together. Tactical positioning should not undo the strategic positioning of the portfolio or change the risk profile. Ask how often the portfolio manager adjusts tactical allocations and what the parameters are for doing so. In the final analysis, successful investing allows clients to reach their goals. Headline performance versus market benchmarks is only one element of the decision process. Strategic and tactical asset allocation and risk and cost management are the largest contributors to goal attainment.
Here's a bold truth: there isn't a secret sauce for portfolio selection for high-net-worth investors. Consistent adherence to basic principles will keep them on the path to reaching their various goals. Helping clients remain focused on their long-term objectives is likely the most valuable service advisors can provide. The quality of portfolio design and modeling matters to your clients—especially in a volatile market environment that has them scared. That's why it's time to talk portfolio design with your clients.
Dan LaPlante, CFA, is the chief investment officer for private wealth management at Citizens Bank.