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Protecting Clients During Volatile Markets

A traditional buy-and-hold approach can inadvertently jeopardize clients’ wealth, since the rules of engagement have changed.

May 15, 2008
Sponsored by Rochdale Investment Management

by Garrett D’Alessandro, CFA, AIF®, Chief Executive Officer and President, Rochdale Investment Management

Most advisors are familiar with Modern Portfolio Theory and the concept of the efficient frontier, which represents the set of various portfolio allocations that provide the maximum return for a given level of risk. Advisors develop portfolio allocations for clients that provide an “efficient” portfolio on this frontier. A common starting point for identifying the appropriate client portfolio is to conduct a risk assessment, through a risk profile questionnaire. As a private client investment manager focusing on high net worth clients, we take a more personalized approach. We have found it helpful to illustrate the drawdown potential and other scenario-based shock tests for various proposed allocations, as this type of analysis can best pinpoint the emotional quotient of risk tolerance. Then we develop a portfolio that manages to the client’s established risk budget.

As a fiduciary, when we begin a client relationship, we develop an investment policy statement for each client that addresses their target range for each asset class, based on their risk budget. For example, cash could be zero percent to 20 percent, and international could be 10 percent to 30 percent. The purpose of this is to allow the client’s portfolio manager the flexibility to operate within these ranges for each asset class, as warranted by economic and market conditions. In times of “normal” markets, the client may be invested at the midpoint of each of the asset class ranges. When the outlook for a particular asset class is stronger than another, we have the flexibility to shift the allocation, within the range, toward that favored asset class. Conversely, the portfolio manager has the flexibility to reduce allocation to a particular asset class when market conditions warrant. Contrast this with a wrap program, which typically invests in a fixed allocation based on long-term market characteristics, and automatically rebalances to the target, regardless of market conditions. For example, stocks in most sectors currently are fairly valued and have strong earnings growth rates and balance sheets. But, with limited guidance and increased volatility, we are not comfortable being fully invested in equities and have modified client portfolios accordingly.

What happens when the rules of the game change, or in this case, the risk? The market today is much more volatile than most clients anticipated or are comfortable with. If you build the same portfolio today as you would have built one year ago, you’re getting a completely different animal. Each individual stock has a higher risk number than it did a year ago. If a client is invested in the same holdings as a year ago, or if you are rebalancing to the historical target allocation, you most likely are exceeding the risk budget that was originally articulated in agreement with the client.

During periods of heightened market volatility, such as what we are presently experiencing, a normally acceptable portfolio allocation is suddenly much more risky. It has shifted to the right on the efficient frontier, without the commensurate reward or risk premium for taking that risk. More importantly, from a fiduciary perspective, the current portfolio is most likely out of the range of the client’s desired risk budget. The advisor must take appropriate measures to diffuse the risk in the portfolio. Increasing cash allocations is one way to protect client capital and help manage anxiety during periods of extreme market volatility and uncertainty. Additional technical tools such as gain capture, stop loss, personalized volatility zones and slower portfolio implementation can help mitigate portfolio risk. The recent market correction also underscores the need to diversify outside traditional asset classes and consider non-correlated, low-volatility alternative investments. Beyond these tools and techniques, of course, constant communication is the best way to calm and retain clients.

With modern portfolio theory and the basic principle of rational markets, many advisors and investors have been trained to just close their eyes and ride it out. But buy-and-hold, in our view, does not address clients’ asymmetric view of risk. Clients do not value gains and losses equally. The emotionally connected advisor has to recognize and respect that, for all their risk profiling, clients do not like losses. Regardless of market theory, clients are loss averse.

Managing risk is a tradeoff, balancing between capital protection on the downside and the opportunity cost of not getting the full 100 percent of the recovery when the market changes. Most high net worth clients are willing to give up some return for protection on the downside and are less concerned with matching the exact benchmark return. This is still modern portfolio theory at work, but from the primary emphasis on risk management.

In contrast, many CPAs and advisors inadvertently outsource risk management to individual fund or separate account managers via various investment platforms. But without an aggregate view or understanding of the overall portfolio cash level, it is impossible to manage client anxiety. A wrap program typically puts new money to work right away, when it may be beneficial to ease into the market to get the client comfortable with portfolio activity and, particularly during periods of uncertainty, to perhaps be substantially out of the market to protect client capital.

During volatile markets in particular, a private portfolio manager relationship brings the proactive risk management, communication, and transparency required to satisfy and retain high net worth clients.

Garrett R. D’Alessandro, CFA, AIF®, is Chief Executive Officer & President of Rochdale Investment Management, a private client money manager specializing in personalized portfolio management for high-net-worth individuals and families. For more information, please call 800-245-9888 or e-mail info@rochdale.com.

This publication is for informational purposes only and is not intended to be a solicitation, offering, or recommendation by Rochdale or its affiliates of any product, transaction, or service, including securities transactions and investment management or advisory services. The opinions expressed in this publication should not be considered investment, tax, legal, or other advice and should not be relied on in making any investment or other decision.