It may sound counter-intuitive, but accumulating wealth is often the easy part of a wealth management strategy. As the recent turmoil in markets has exposed, to grow, or even just maintain, wealth is more complicated than it would initially appear. Most people recognise that it is not enough simply to invest, but what decisions go into building an investment portfolio? How do people know whether they are being well-served by their investments? Any investment needs to have a purpose. This will determine the investment’s time horizon, the amount of risk that can be taken and whether it needs to be focused on income, capital preservation or growth. Dani Glover, director of financial planning at Smith & Williamson, says: “We need to know why anyone is saving or investing. If someone is saving for something a year away, they shouldn’t be in an equity portfolio. Equally, if someone wants to build wealth over the longer-term, you shouldn’t have them all in cash. The financial planning comes first and the investment management comes second.”
Most financial advisers will therefore spend early meetings building an understanding of a person’s needs and aspirations. Bill O’Neill, chief strategist at Merrill Lynch Wealth Management, says: “The key thing’s to know our clients’ goals over a period of years and decades. This’ll encompass life planning and succession planning, what they need to maintain their lifestyle, what they need to do to improve their lifestyle and how they will protect their portfolio against time.” Before any investment decisions are made, clients should have clear and honest goals.
Risk tolerance will also be an important consideration. Most advisers will undertake some kind of psychometric profiling to establish an individual’s attitude to risk. O’Neill says that it is important to understand someone’s loss aversion versus their appetite for gain: £1 gained seldom feels the same as £1 lost. Advisers will also need an approximate target date for an investment and an understanding of the level of liquidity each individual will need.
Financial planning needs will also be dictated by the way people are paid. Iain Tait, director, private clients at London & Capital, says: “Many lawyers have the characteristics of a self-employed person. There’s some unpredictability in their future income stream and they may not be able to see more than 12-18 months ahead in terms of fees. Therefore, they may need a slush fund.” Equity partners can expect a lump sum on retirement, which in turn may affect their retirement planning needs. This lump sum may be subject to Capital Gains Tax, depending on how the partnership is structured.
Once these objectives have been established, advisers are likely to look at tax considerations before they move on to the investment portfolio. Historically investments and tax wrappers have been sold together, but increasingly wrappers – including pensions, Isas and investment bonds – are commoditised and the investment portfolio is simply allocated to the most appropriate tax wrapper.
In establishing what a portfolio should look like, an adviser will have to take account of what tax wrappers are already held. Tait says: “The likelihood is that most clients that come to us will have accumulated a mismatch of different wrappers – Sipps [self-invested personal pension], investment bonds, collectives. Much of our first meeting with a client will be making sure that assets are housed within the most tax efficient structures.”
There are also tax planning decisions that may be determined by the kind of firm a lawyer works for. For example, Malcolm Cuthbert, financial planning partner at Killik & Co, says: “Some lawyers, usually in provincial practices, will use Sipps to buy their business premises. A number of the partners will gather together and form a syndicate.” This has become harder with the new tax restrictions for high earners, but gearing of up to 50 per cent can be employed and it still represents a sound option for those with earnings of below £150,000 or for cheaper premises.
The mix of tax wrappers has become very important following the changes in the pre-Budget Report. The report changed the pension tax regulations for high earners, eroding the higher rate tax relief for those earning over £150,000. This means that in some cases Isas can be a more efficient way to save for retirement. Cuthbert says: “Isas have become a very attractive planning tool, now that investors can get in £10,200 per person per year. Over a 25-year period, investors can accumulate over a million pounds in order to generate a tax-free income.”
It is only now that an investment decision needs to be made. There are two parts to this decision. The first is the asset allocation of an investment portfolio. This is the mix of different asset types, including the allocation to fixed income (government and corporate bonds), equities (stocks and shares), cash, property and alternatives such as hedge funds or private equity. The second is the underlying discretionary manager, fund manager or individual investments.
Again it is important to have a full picture of existing investments. Tait says: “We want to look at the whole family’s assets. If someone’s wife has a property portfolio and it’s not incorporated into the recommendation, the balance of assets will be wrong.
The portfolio may be over-concentrated in one area.”
Shake that asset
In general, risk used to be thought of on a sliding scale from government bonds (very low risk), though blue-chip corporate bonds and then higher risk corporate bonds, to blue chip equities and finally smaller companies and emerging market equities, which were considered the highest risk. In practice this has been distorted by the financial crisis and recession. Lee Robertson, managing director of financial planning group Investment Quorum, says: “We’ve found our clients to be too UK-centric. The West has the debt and the East has the capital, so ’emerging markets’ have become a bit of misnomer. We’ve found that asset allocation should be broader and more international.”
The asset allocation blend of a portfolio will also vary according to the views of the manager as to the likely performance of different assets. Groups will vary in the range of asset classes they use, particularly in whether they use alternatives, and the extent to which they switch between those asset classes. Chris Sexton, investment director at Saunderson House, says that the group works with just four asset classes – bonds, equities, property and cash – but will allocate actively between them. For example, the group sold out of commercial property in 2006 and has only recently bought back in. Other groups may use a broader range of assets, but will hold more static asset allocation models.
Sally Tennant, chief executive at Lombard Odier, believes diversification can be over-played: “A lot is said about not putting your eggs in one basket, but people can end up spreading risk for the sake of spreading risk and not looking properly at the cost of assets. Valuation is very important, because if you buy when assets are over-priced you won’t have as much chance of making money.”
In setting these goals, Tennant says: “Keeping hold of your money shouldn’t be underestimated. If you get a lump sum and spend 5 per cent of the capital annually, after 20 years your net worth will be reduced by 27 per cent. You have to ask yourself how much you can afford to spend and the extent to which you can impair your capital.”
Equally it is tempting to focus on the more complex investments, but focusing on good cash management is a simple way to add incremental returns to an investment portfolio, particularly with few savings accounts’ rates matching inflation. Robertson says: “We’ll look at clients’ bank accounts, national savings or cash Isas. In general, if someone can tie money up for a year or more, they’ll get a better rate.”
After the appropriate asset allocation has been determined the secondary consideration is to decide on an appropriate mix of underlying assets. Many investment groups will take both the asset allocation and the investment decision away all in one. Groups such as Killik, Smith & Williamson and Rensburg Sheppard all offer discretionary management services. In practice these discretionary services vary considerably. At the top end is the traditional private client wealth management approach, where a bespoke portfolio is created for every client. This is likely to be invested in direct equity with a few collectives for specialist areas.
The manager may consult on decisions taken and will be able to adjust the portfolio to take account of a client’s existing holdings. This type of approach becomes viable with portfolios of £250,000 or above.
At the other end of the scale are the ’mass market’ discretionary services. These have a lower entry level, usually rising from £50,000. Each investor will be slotted into one of a number of asset allocation models according to their time horizons and risk tolerance. In each case investors should ensure that they are not paying for a bespoke portfolio and getting a model portfolio.
Multi-manager funds such as those offered by Jupiter Unit Trust Managers, Thames River Capital or Cazenove Capital Management can be a good choice for those with less to invest. Minimum levels usually start at £1,000 per fund and they are available through advisers, brokers and fund supermarkets. These products will offer a blended portfolio of funds and their managers should have the skill to switch between different products at the appropriate point in the market cycle. They will not be bespoke, but investors can choose between funds with different risk profiles.
For those who want to take a more self-select approach, rating agencies such as Morningstar, OBSR, Citywire or Trustnet will offer guidance on collective investments such as OEICs (open-ended investment companies) or unit trusts. Most will have a ratings system that grades funds according to their own criteria. Equally, discount brokerage groups such as Hargreaves Lansdown or Chelsea Financial Services will have buy lists of their favourite funds.
How can performance be judged? With discretionary funds, this will depend on the benchmark of the investor. Some may want their investments simply to beat the return on a bank account, whereas others may want their investments to keep pace with the equity market. In either case, the benchmark should be clear up front and managers should have a coherent explanation if they have underperformed, though most only aim to do so over a three-year period rather than month on month.
Individual funds, including multi-manager funds, will have specific benchmarks that they aim to beat. However, as the FSA is fond of repeating, past performance may not be a good guide to the future. Tennant says: “It’s important to ask your investment manager how they’ve done in different types of market environment.” The manager who outperforms in a bull market is unlikely to be the same manager that can protect capital in a bear market.
In all investments fees are crucial. The difference between £100,000 invested for 25 years at 6 per cent or at 7 per cent is £126,045 – 1 per cent extra in management fees can made a significant difference over the longer-term. Sometimes it can be worth paying extra for good quality discretionary managers, but they need to earn their additional fees.
Tennant offers some final words of wisdom for those devising their investment strategies: “Investors get bullish when the market goes up and bearish when the market goes down. The crowd can be wrong at extremes.
All stocks and economies tend to mean revert. A good sailor doesn’t do well because of spreadsheets, he simply aligns himself with the prevailing wind.”