Practical analysis for investment professionals
12 September 2012

Asset Allocation for Private Clients: One Part Theory, Two Parts Emotion

In 2005 I was asked to organize the annual CFA Institute wealth management conference for the first time. This presented a challenge because I didn’t know much about “private wealth” and why it should be considered differently from institutional investing. I had heard repeatedly that private wealth is  “more than just taxes,” but I didn’t really understand what that meant, and hoped I would be able to put together a relevant program.

When it was held in March 2006, the conference went pretty well, but two talks in particular stood apart from the rest and changed my thinking about private wealth management. They ultimately led to a whole new conference series tailored for those managing private client assets.

The first of these was Ashvin Chhabra’s opening talk. The previous year, Chhabra’s “Beyond Markowtiz: A Comprehensive Wealth Allocation Framework for Individual Investors” was published in the Journal of Wealth Management. I was impressed with the article and was fortunate to line him up to open the conference. Ashvin began his talk by reviewing modern portfolio theory (MPT) and its fundamental assertion that combining uncorrelated asset classes creates a portfolio superior to one concentrated in the “best performing” asset classes.

All well and good for those who have already acquired wealth, but as Chhabra said in his talk, if you didn’t marry or inherit your fortune, chances are you built it by creating or investing in a business that succeeded against the odds, or invested in real estate, probably utilizing leverage, in the right market at the right time. In other words, wealth is created through inherently risky, undiversified strategies with a high chance (and incidence) of failure — strategies that would be out of bounds for the investor strictly following the tenets of MPT.

This paradox led Chhabra to ask, “What theory allows for wealth generation over and above a reasonable risk-adjusted return on a diversified portfolio of assets?”

The answer? By utilizing the Wealth Allocation Framework (WAF), investors accept below-market returns on a portion of their wealth in order to sufficiently safeguard this portion of their capital — and free up capacity to take “aspirational risks” that could lead to yet more wealth creation.

The crowd was buzzing after Chhabra’s talk, and with good reason. While far more complex than I’ve just described, Chhabra’s Wealth Allocation Framework is conceptually intuitive and, since its original publication, it has been widely cited in the growing literature on goals-based wealth management, an approach to risk budgeting and asset allocation that integrates personal perceptions of risk and a spectrum of investment goals that likely wouldn’t be achievable strictly through mean-variance optimization investing.

The last speaker at the conference that day was Scott Welch, whose session I’d named “New Frontiers in Taxable Asset Management.” Even at the time, I realized this was an unrealistic topic for a one-hour session — the conference planning equivalent, Chhabra might say, of an “aspirational risk.” Nonetheless, I was very pleased that he agreed to give the talk, because I hadn’t the foggiest clue what the future of wealth management looked like, and I hoped someone would be able to tell me.

Like Chhabra earlier in the day, Welch examined MPT from the perspective of the private client and found it wanting, largely because its measure of portfolio risk — standard deviation of returns — is not intuitive or easily explained to wealthy clients (who, by the way, like upside volatility just fine but abhor losses, regardless of how you did against an abstract benchmark). Welch maintained that tools suitable for institutional money management, while valuable in many respects, are not sufficient to meet the needs of the private client trusting you to manage their money.

The “new frontiers” of wealth management, Welch suggested, might therefore be oriented more towards nontraditional investment strategies and ways to look at risk and return that would not only be more intuitive to private clients, but would also be more effective in helping them define and meet their goals, whether they be philanthropic or dynastic in nature. This is, of course, easier said than done, but it is precisely the sort of challenge that Chhabra’s Wealth Allocation Framework was designed to address.

After seeing those two sessions — which, by the way, are still available for viewing — I suddenly understood why building and communicating an asset allocation strategy for a wealthy individual or family is vastly more complicated than doing the same for an institution, even setting aside the complex issue of taxes.

Experienced investment professionals would understand that an individual’s risk appetite and return expectations are uniquely personal and are shaped by any number of influences and experiences. Helping a client understand and articulate their own goals and their biggest fears, and then building a compatible investment strategy, is an enormous challenge and is likely to be different with every client. This, I believe, is the essence of private wealth investing and what separates it from institutional money management.

That evening, after his talk, I asked Scott Welch if he would be willing to assist us in developing a new conference, titled Asset Allocation for Private Clients, that could explore these ideas in greater depth. I was delighted when he agreed. Since 2006 we’ve held the AAPC conference three times. At each, we’ve explored new asset allocation strategies and alternative asset classes in the context of current economic and geopolitical developments, and all from the private client perspective.

I’m very pleased to announce that we’ve scheduled a fourth in this series, and invite you to join us next month in Atlanta (17–18 October 2012) as we continue the conversation. Chhabra and Welch will both be back, along with a terrific lineup of practitioner speakers including:

  • Robert Gordon of 21st Securities on the tax implications of hedge fund investing,
  • Professor Cam Harvey of the Fuqua School with new research on gold,
  • Rick Ferri, CFA on the use and mis-use of exchange traded funds, and
  • Willis Sparks of Eurasia Group on geopolitical risks that will impact investments in the years ahead.

Check out our conference webpage for more information about Asset Allocation for Private Clients. I hope we’ll see you in Atlanta next month for what promises to be a fascinating discussion.

About the Author(s)
Charlie Henneman, CFA

Charlie Henneman, CFA, is head of educational events and programs at CFA Institute. Previously, he was the director of structuring and operations at Indosuez Capital, the CDO (collateralized debt obligation) management group of Credit Agricole Indosuez. Henneman previously held several positions in credit and structured finance, including managing director at advisory boutique AGS Financial, senior vice president and chief credit officer in the new products and ventures group at Enhance Financial Services Group, Inc., and director in the new assets group on Standard & Poor's structured finance ratings team. He holds a BA in political science from the University of Rochester and an MBA in finance from the New York University Stern School of Business.

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