Best Practices in Designing Investment Portfolios for Families
Now that we've reviewed the asset allocation process in a general way, along with some of the issues associated with it, let's take a look at how the best advisors and families approach the challenge of designing thoughtful asset allocation strategies.
What Are the Objectives for the Portfolio?
While most institutional portfolios have similar objectives,15 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 on the return on their capital. It's not that high returns are unimportant—it's that private capital is irreplaceable. Most families who 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 because 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 percent and an institution's equity portfolio is down 28 percent, the institution has outperformed relative to the indexes and is, at least theoretically, satisfied. But a family whose equity portfolio is down 28 percent is unlikely to be satisfied, theoretically or otherwise.
Note, also, that unlike institutions, families often hold their wealth in radically different “buckets” and these buckets 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 current 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 a much higher-risk approach.
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 Claims versus Growth Claims on a Portfolio
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 basis16—both current and future claims on it.17
Current claims include the family's spending needs, including 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 (that is, 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 over time: 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.18
Matching Portfolio Assets to Each Type of Risk
As everyone knows, 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 portion 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.
Obviously, the asset allocation selected for a client's portfolio has to be right. But very nearly as important is the way an advisor frames the issues and discusses the process with the client.
All too often, asset allocation strategies seem to the client to have emerged from an incomprehensible black box. The family might implement the strategy—what choice do they have?—but that doesn't mean they understand the first thing about it, or why it was selected, or how it is likely to perform over time. As a result, the strategy will be abandoned at the first sign of trouble—the very worst-case outcome for a family (and also for the advisor!)
As noted previously, I recommend talking to the family about asset allocation not in modern portfolio theory terms, but in terms of current and future claims on a family's capital. This is something family members can understand, even if they've never bought a stock or bond.