Portfolio Construction and Monitoring

Portfolio Allocation and Investments for Private Wealth Clients

The traditional approach to constructing a private client’s portfolio views risk in an overall portfolio context and consists of the following steps:

  • Identify asset classes. The wealth manager identifies the asset classes that may be appropriate for the client’s portfolio.
  • Develop capital market expectations. The wealth manager considers the expected returns, standard deviations, and correlations of asset classes in relation to the client’s investment horizon. Wealth managers typically update their capital market expectations according to changes in the financial market environment.
  • Determine portfolio allocations. Wealth managers sometimes use mean–variance optimization to identify possible portfolio allocations that meet the client’s return requirement and risk tolerance. Mean–variance optimization provides a framework for determining how much to allocate to each asset to maximize the expected return for an expected level of risk.
  • Assess constraints.
  • Implement the portfolio. At this stage, the wealth manager faces several decisions. One decision is the choice of active management or passive management for each asset class. Once that decision is made, manager selection becomes an important consideration. Another decision for the wealth manager is which factors to recommend within a given asset class. Such factors may include “value” and “size”. Implementation also involves a decision to utilize individual securities or pooled vehicles, such as mutual funds and ETFs. Finally, the decision to apply currency hedging can be another important implementation decision.
  • Determine asset location. When a client’s portfolio comprises multiple accounts, the wealth manager must determine where to allocate the various asset classes and securities. This allocation decision is called asset location. Generally, tax considerations are a critical factor for asset location.

Goals-based investing essentially follows the same steps as the traditional approach to portfolio construction, the critical difference being that instead of constructing a single portfolio, the private wealth manager creates separate portfolios for each of the client’s goals.

Mean-variance optimization, which can be structured to maximize expected returns for a given level of risk or to meet a specified probability of success, is carried out for each goal portfolio rather than for the entire portfolio.

With goals-based investing, clients may find it easier to specify their risk tolerance, as this is expressed for each goal portfolio rather than for the client’s entire portfolio.

A key disadvantage of this approach is that the client’s entire portfolio may not be mean-variance efficient.

Portfolio Reporting and Review

A portfolio report for a private client typically includes the following items:

  • Performance summary for the current period.
  • Market commentary for the current period to provide context for the portfolio’s performance.
  • Portfolio asset allocation at the end of the current period, including strategic asset allocation weights or tactical asset class target ranges.
  • Detailed performance of asset classes and individual securities.
  • Benchmark report comparing asset class and overall portfolio performance to appropriate benchmarks.
  • Historical performance of client’s investment portfolio since inception.
  • Transaction details for the current period
  • Purchase and sale report for the current period.
  • Impact of currency exposure and exchange-rate fluctuations.
  • Progress toward meeting goal portfolios when using a goals-based investing approach.

Wealth managers often face an inherent conflict between the client’s investment horizon, which may be decades in length, and the typical performance evaluation horizon, which may be one calendar quarter or one year. This horizon mismatch can potentially undermine long-term investment decision making.

A portfolio review enables the private wealth manager to reassess a client’s IPS and investment strategy in light of recent performance to determine if changes are required. A portfolio review typically addresses the following areas:

  • Appropriateness of client’s existing goals and investment parameters and if any changes are required.
  • Rebalancing of portfolio asset allocation to target allocation or ranges.
  • Any changes to the wealth manager’s ongoing management of the portfolio
  • Any changes or updates in the wealth manager’s duties and responsibilities.
  • Any changes to IPS and portfolio review frequency.

Evaluating the Success of an Investment Program

The degree to which a private client’s investment program is considered a success is measured in terms of three criteria: goal achievement, process consistency, and portfolio performance.

A successful investment program for a private client is one that achieves the client’s goals/objectives with an acceptable amount of risk. 

Due to the ongoing nature of the investment program, the criteria for success should be whether it is still likely to meet the client’s longer-term goals without a significant change in the original strategy.

The success of an investment program also depends on the consistency of processes that the manager uses. The following issues are typically considered in evaluating process consistency:

  • Has the wealth manager implemented an investment strategy that is consistent with the client’s goals and investment preferences?
  • Is the wealth manager maintaining regular communications with the client to assess the need for changes to the IPS?
  • How have recommended third-party investment managers performed relative to their benchmarks?
  • What is the impact of recommended fund manager switches on portfolio performance?
  • How has the use of tactical asset allocation affected portfolio performance (if applicable)?
  • Has the rebalancing process followed IPS guidelines?
  • What tax-efficient strategies have been employed for the portfolio?
  • How has the wealth manager tried to reduce portfolio costs and expenses?

Finally, portfolio performance can be measured against an absolute performance benchmark or relative to a passive benchmark.

The impact of investment risk can be evaluated by comparing the risk-adjusted return of the client’s portfolio and an appropriate benchmark and by comparing the portfolio’s downside risk with the client’s risk tolerance.

Private wealth managers and their clients should ideally agree on the measures of success at the inception of the investment program to avoid misunderstandings further down the line.

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