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Complex Portfolio Construction Sounds Sexy, But It's Burdensome And Doesn't Benefit Clients
With today's increasingly astute and savvy clientele, financial advisors are under more pressure (some of it imagined) to convey their value proposition to current and prospective clients.
In bygone eras of financial services, an easy way for an advisor to prove his or her worth to clients was to use unnecessarily complex portfolio construction. Think of it as the “I'll take it from here” approach to investment management.
Here's a quick hypothetical example to illustrate this antiquated way of thinking. Advisor Joe has a client, Jerry. Jerry's a dentist and as such has advanced education and a decent net worth, but as a dentist, his expertise is in gums and teeth, not financial markets. Of course, Advisor Joe knows this and exploits this fact by promising Jerry boffo returns using an array of complex (and likely expensive) investment strategies and techniques.
One way for advisors to think about unnecessarily complex portfolio construction is to think about hedge funds. Or, one reason for advisors to eschew hard-to-understand investment strategies is hedge funds.
“The HFRI Asset Weighted Composite Index declined 2.4% in the fourth quarter, according to Hedge Fund Research, as U.S. stocks fell 13.5%,” according to Barron's. “That completed a solid calendar year when hedge funds outperformed public equities. The index of hedge fund returns slid 0.7%, while the S&P 500 dropped 4.4% and the Barclays Capital Government/Credit Bond Index lost 0.4%.”
That sounds good, right? Wrong. Last year was the first time in awhile that a broad basket of hedge funds topped the S&P 500. For the proceeding five years, the market crushed complex hedge funds.
“For the five years leading up to that, hedge funds have failed to beat the S&P 500’s returns, including dividends, like last year, when the HFRI Asset Weighted index generated 6.7%, while the stock index gained 21.8%,” notes Barron's.
Promises, Promises
There are other issues with complex client portfolios, not the least of which include advisors assembling something that appears to be alpha-generating only to find out later the practice lacks the resources to adequately manage higher maintenance offerings.
The more complex a strategy is, the more monitoring and nurturing it needs, and that can pull advisors away from other areas of the practice.
Then there is the issue of fees, something you can rest assured clients are talking about among themselves even if they're not discussing it with you. Generally speaking, the more complex a portfolio is, the more expensive it is for a client. No, we're not saying throw all your clients' capital into Vanguard index funds and call it a day. What we are saying is that with today's increasingly fee-conscious clients, the more expensive a product or strategy is, the better it should perform in the eyes of clients. Of course, the advisor cannot make that guarantee.
Finally, there's the issue of trust. It's often said in life that it's better to under promise and over deliver. This is certainly true for advisors. If promises are going to be made, pledge benchmark returns or benchmark performance with perhaps less volatility. By pushing clients into complex strategies, you are creating return expectations that may be difficult or impossible to meet. One those expectations are not met, the client feels jilted and trust is violated.
Bottom Line: Define “Complex”
Initiate a conversation with clients about their levels of risk tolerance and their understanding of investment complexity. Earlier, we used the example of hedge funds as examples of complex vehicles, but there are other avenues for advisors to take that have more “curb appeal” than the basic 60/40 equity/fixed income split.
Alternative assets (it can be as simple as gold), new generation private opportunities (cannabis testing and shared space) and real estate are examples of investments advisors can discuss with clients to prove their value beyond stocks and bonds without engaging in highly risky or complex advice.