Advisors and their clients all too clearly remember the financial crisis of 2007 to 2008. Recent events in the Middle East and Japan have caused these memories to come to the forefront, re-sensitizing investors to "black swan" risks that were previously unimaginable. The impact of the ongoing tumult is that investors are more focused than ever on managing volatility and finding ways to protect their portfolios while still seeking market-beating returns. The good news is that these investors are now aided in this quest by new methods in portfolio construction, supported by advances in technology. Taken together, these innovations in tactics and technology offer the promise of upside investment potential coupled with downside protection.

"All the volatility in the last few years has resulted in creativity on the part of strategy providers and investment managers," says Scott Egner, manager, TD Ameritrade Institutional's Managed Account Solutions. "Technology has made this happen, with the ability to deliver many strategies in a single account a driving force behind the changes."

New Thinking

Pre-crisis portfolio construction techniques and practices no longer go unchallenged by investors, in part because the real-life stress test of the last few years exposed weaknesses. Says Robert Hussey, executive vice president, institutional services, at Natixis Global Associates, "Since the crisis, traditional asset allocation has been questioned. The idea that long-only equities or credit provide enough diversification has been questioned. And the tools implementing diversification have also been called into question." The answers to these questions are coming from the investment management industry itself, which has risen to the challenge by formulating-and executing via new technology-new portfolio solutions.

Take Hussey's company, Natixis Global Associates, a "multi-boutique" asset manager: Its offerings to advisors emphasize diversification by striving for uncorrelated outcomes not just during good times but during crisis periods as well. Many of these strategies may have previously been termed "alternative" but are now in the mainstream of portfolio construction and investment selection. One distinction from previous alternative approaches, however, is a tighter focus on risk management and protection as the primary investment objective, while maintaining liquidity.

On the equity side of the equation, for example, the company offers mutual funds that are hedged by selling calls and buying puts. The strategy delivers beta-like returns without the swings of an unhedged portfolio. Similarly, with investment manager AlphaSimplex, the company offers a unique hedge fund "beta" replication, reflecting returns from across the hedge fund universe, aiding in diversification. Natixis' own strategy is to provide these alternatives in a structure that is transparent, liquid and low cost, namely in a mutual fund. These funds may not deliver all the alpha of a traditional hedge fund, but instead offer diversification and volatility management, critical for today's risk-sensitive clients. Says Hussey, "Our goal is to target alternative strategies, analyze how they fit into the portfolio context and provide them in a structure that RIAs can offer to their clients."

Using tactical managers to take advantage of market turmoil is another way RIAs and the investment industry are rethinking portfolios in a challenging macro environment. Says Egner, "What I'm seeing out in the marketplace right now is interest from advisors in taking a strategic allocation and coupling it with tactical exposure through managers who use exchange-traded funds." The advisor retains control over strategy, meaning long-term asset allocation. But when it comes to tactics, meaning short-term allocations within the overall strategy, the advisor utilizes specialist tactical managers who are well positioned to exploit market disruptions.

These tactical approaches can have different themes, such as macro, sector based or commodity focused.

Tactical managers are able to adapt to the economic environment around them, doubling up on an exposure or

cycling in and out of different metals like gold or silver; they are given the latitude that doesn't exist for a traditional mutual fund manager.

Moreover, as Egner points out, the managers are implementing their ideas via ETFs. This brings with it broader diversification, allowing investments in risky underdeveloped regions, like frontier markets, without taking on specific company risk. ETFs are also being used to create synthetic exposures that mimic alternative strategies, providing a low-cost "alternative" to alternative investments like long/short strategies.

"Using tactical managers and ETFs, RIAs can build a very well-constructed portfolio that can better manage risks," says Egner. With the tactical approach, he adds, "investors can gain exposure to asset classes and also investment styles that are much less correlated, mitigating volatility."

One challenge for advisors implementing these new moves in portfolio construction is how to benchmark tactical managers. Asks Brad McMillan, chief investment officer at Commonwealth Financial Network, "Is it fair to benchmark someone running a tactical portfolio to the S&P? My argument is no." A tactical manager should be able to outperform the market, specifically on the downside. Therefore, McMillan argues the correct benchmark is a moving-average strategy. In its simplest form, the strategy involves staying in the market when it closes the day ahead, and selling or staying out when the market declines for a day, resulting in a "moving average." Says McMillan, "This creates a potential and better benchmark for tactical strategies."

Moreover, as McMillan points out, benchmarks tie together different points. In this case one point is generating alpha, which must involve a benchmark that the strategy "outperforms, and another is managing volatility, which in practical terms means managing the downside.

However, advisors don't necessarily need to turn to complicated strategies to accomplish all these tasks. "Simplicity is a virtue as well," says McMillan. Traditional dollar-cost averaging is one effective way to play market turmoil. And in terms of fixed income, McMillan still likes Treasuries. "In a world of great uncertainty, United States debt, despite the growing deficit, is not as bad a bet as it has been portrayed," he says.

New Technology

Many of these cutting-edge portfolio construction ideas are heavily reliant upon technology-for execution as well as reporting. Says Timothy Welsh, president and founder of Nexus Strategy, a strategic marketing consultant to the wealth management industry, "The rise of new applications, particularly rebalancing tools and performance-reporting systems that are online and in real time, really improves the ability of the advisor to put together thoughtful portfolios that match the investment environment."

He offers this example: Suppose an advisor has 300 portfolios and wants to move into bond funds. To move all these portfolios individually, submitting trades using traditional software could take days or at the very least hours. But with new technology or a technology-assisted software platform, the advisor or manager can make changes immediately. Some companies are so far along in embedding technology in their operations that the entire investment process is digital. Welsh describes Asset Dedication, a California-based portfolio engineering firm as the poster child for the technological approach; their entire process is paperless. He adds, "The volatility in markets today is simply too great for the old style of technology."

New technology solutions run the gamut of possibilities. For example Fiserv, a Wisconsin-based provider of information management to the financial services industry, offers solutions that range from accounting and trade processing to portfolio management, reporting and billing. Though these are all useful for wealth managers, the platform also offers the possibility of comprehensive financial planning, goal-based investment proposals, investment analytics and statistics, including back-testing of portfolios. Says Pierre Bossaert, director, product management investment services at Fiserv, "These tools allow the advisor more efficient, integrated and analytical approaches to portfolio construction, including the potential for generating alpha."

Another technology trend he has observed is additions and changes to the unified managed household (UMH) and unified management account (UMA) platform. Bossaert says, "The whole concept of the household, rather than just the individual investor, is coming into view." In the past, investment construction and proposal tools for household members were often entirely account-centric; now goal-based investment proposals across multiple accounts are joining comprehensive financial planning with a focus on the entire household. Moreover, as recently as five years ago, the basic UMA only offered a limited number of investment products; tactical strategies were rare or unknown. Today, hundreds of investments can be commingled in a single UMA account, making tactical and strategic decisions that much easier. Says Bossaert, "The advisor now has improved tools for building, implementing and reporting on the portfolio, as well as running it tax efficiently from a single, holistic and integrated wealth management platform."

Technology is also changing how advice is being delivered. Clients will be able to access their accounts through mobile devices rather than through a PC or paper. And advisors will be able to communicate with their clients through multiple channels.

The results of these tactical and technical changes are positive for the wealth management industry. Portfolios will be more robustly constructed and trades efficiently executed. Even better, the changes could make advisors' lives easier. Says Welsh, "By removing all that clunky stuff through technology, the advisor has more time to focus on investment strategy. And the key piece here is they now have more time to communicate with and educate the client."

Register or login for access to this item and much more

All Financial Planning content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access