Monday Morning: Keeping the clients’ liabilities in mind

The key question for financial planners isn’t: What should the client’s long-term asset allocation be? Nor is it: What will be the long-term rate of return on stocks?

The big question is: What are the investors seeking to achieve through their investments?

The answer is simple but not always remembered: Investors are trying to fund streams of liabilities. They’re trying to determine how much must be saved and how the savings should be invested so that there’s a high probability of having enough money to fund those liabilities.

Unfortunately, individual and institutional investors, and the advisers and consultants who guide them, too often lose sight of this fact. They become distracted by issues such as the expected long-run rates of return of stocks versus bonds, or which particular mutual fund or money manager is the best fit for the portfolio.

Only when advisers focus on the key issue of funding a liability stream are they likely to provide the correct advice for their clients.

This timely reminder that the basis for successful investing rests in the recognition of the core problem comes from Kevin Kneafsey, investment strategist at Barclays Global Investors in San Francisco.

Mr. Kneafsey has written a paper in response to a recent essay by Peter L. Bernstein, author of “Against the Gods: The Remarkable Story of Risk” (John Wiley & Sons Inc., 1996) and “Capital Ideas: The Improbable Origins of Modern Wall Street” (The Free Press, 1993), two of the best finance books of the 1990s.

shorter-term outlook

Mr. Bernstein, an economic consultant, says in his essay that policy portfolios – those that define an investor’s long-term strategic asset allocation – are obsolete.

He says investors shouldn’t hitch their stars to policy portfolios. That’s because the notion that one particular asset allocation structure – 60/40, or 90/10, or whatever – is going to be appropriate for all seasons is an extraordinarily risky assumption on which to manage wealth. Given the uncertainties, the investor’s portfolio should be more flexible and responsive to the shorter-term outlook, he says.

Mr. Bernstein addresses institutional investors who are more overt in their use of policy portfolios than financial planners and investment advisers. But most advisers also establish policy portfolios, at least informally, for clients, based generally on age and risk tolerance, and then keep the clients’ asset mixes close to the policy levels.

Mr. Kneafsey contends that the problem with policy portfolios, as they have so far been used, is that they wear two hats.

First, they are designed to hedge the liabilities the investors are seeking to fund. Second, to reduce costs, they are also supposed to generate growth above the level needed to fund the liabilities. That’s dangerous because such an approach requires bets on an uncertain future.

A policy portfolio should wear only one hat, he says. It should be constructed solely to fund the liabilities, and it should behave very much like the liability the investor is trying to fund.

The portfolio must be built with a clear understanding of the structure of the liability stream. For example, the adviser must help the investor determine how much the investment portfolio must generate each month, quarter or year to satisfy the investor’s needs.

Then, after taking account of a client’s savings, the adviser must choose the mix of assets that will deliver the needed cash flows with a high degree of certainty.

Any return the investor desires in excess of the minimum, i.e., any alpha, should be sought outside the policy portfolio. This is easier for institutional investors than for individuals to achieve, because they can use the full range of derivatives to generate alpha while hedging away market risk.

In agreeing with Mr. Kneafsey in a later essay, Mr. Bernstein suggests that investors (or their advisers) can use futures on the Standard & Poor’s 500 stock index or bond indexes to seek alpha without disturbing the policy portfolio.

But, he says, they must always remember: Investing is a procedure for financing future expenditure streams.

A policy portfolio is a portfolio designed to hedge those liabilities. That is the foundation on which we build everything else we require in managing wealth.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.