Le Temps (02.03.2020) - Institutional and discretionary asset managers are increasingly using the same decision-making tools and investment techniques.
This trend has helped make discretionary asset management a more professional discipline, with the creation of dedicated teams. Although it has also caused asset management (AM) and wealth management activities to become more similar, each investor profile has specific features that must be taken into account.
Just because similar techniques are used, it does not mean that all investor profiles are the same: institutional and private clients approach risk in different ways, and this has major consequences when putting together a portfolio. Private clients do not have the same risk appetite or time horizon as institutional investors. Logically, therefore, banks must adapt AM investment techniques to the needs of private clients. The expectations of private clients regarding risk and return and market risk exposure cannot be met using an institutional approach.
Resilience before performance
Whereas an institutional client’s investment profile tends to be symmetrical, that of a private client is convex: the manager needs to create portfolios that are more resilient to market shocks, even if that means returns being a few points lower. This asymmetry is hard to understand without taking into account the psychology of private clients, whose risk tolerance can vary not just over time but according to the market context.
A private client’s investment horizon can also fluctuate, but remains shorter than that of institutional investors, which by nature take a long-term view. This is because private investors have their own money at stake, while their need for liquidity also shortens the period over which their assets can be tied up.
Similarly, private investors often want their portfolios’ returns to be in line with those of the markets when the latter are doing well, sometimes forgetting the opportunity cost of achieving this convexity. As a result, to capture most of the market’s upside while ensuring that the portfolio is resilient on the downside, a premium must be paid to protect capital in the event of a downturn, as with a call option. Any private bank wanting to practice discretionary asset management in a way that is modern and suited to private clients’ needs must therefore be able to devise investment processes that combine agility with AM investment techniques.
Whether dealing with a specific client or a category of clients, putting together this kind of asymmetric portfolio always requires a tailor-made approach. It requires elaborate risk management models using quantitative tools to analyse the behaviour – i.e. the risk/return profile – of assets in the portfolio.
Since portfolios are designed to be convex, they are already protected against unexpected external shocks. As a result, this approach has the advantage of reducing the need to adjust the portfolio and of limiting tactical decisions intended to improve market timing, which actually destroy value for the client.
However, avoiding market timing does not mean that the approach is passive. The portfolio is actively managed in the sense that asset allocation and portfolio structure are actively adjusted.
Whereas discretionary asset managers mainly used to take a directional approach, with occasional protection for some parts of the portfolio, the modern need for asymmetry requires extensive use of short-term derivatives (over 30% of the portfolio) alongside traditional assets.
Balancing the ingredients
This means that an actively managed, convex portfolio is a mixture of directional, asymmetric and protection instruments. Directional instruments must ensure that the portfolio’s return is linked to that of the market, while asymmetric instruments allow that index-linking to be varied according to market signals. Protection involves paying premiums, with the aim of safeguarding the portfolio effectively during times of stress at the lowest possible cost. The combination of these three types of instruments directly determines portfolio returns and volatility, and the challenge is to get the balance right.
To design portfolios that include derivatives and protection, managers must have an excellent understanding of these instruments’ relative behaviour and of their combined movements. As a result, they need quantitative asset management skills and high-level expertise in derivatives and product structuring, expertise that was until recently a niche area within investment funds but is now centre-stage.
Switzerland, the birthplace of private banking, has a clear edge in this area, because there are few domestic private banks in other countries that can offer this level of technical expertise and customisation. Swiss banks can therefore use this competitive advantage to conquer new markets previously regarded as unpromising sources of business for “traditional” discretionary asset management.
Michaël Lok
Co-CEO Asset Management
