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How to build purpose-based portfolios

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As advisers and investors seek new ways to build and manage portfolios in the wake of the great “risk on," central-banked-fueled equity market rally of the past several years, one clear trend in the high-net-worth advisory community is the adoption of a “purpose-based” portfolio construction approach.

What does this mean?

The high-net-worth consulting model is a direct descendant of the institutional model. Unfortunately, the institutional model has certain characteristics (e.g., infinite time horizon, oversight by committee, and tax-exemption) that do not fully apply to individuals, certainly not with any consistency. Rather, individuals are goals-based and, in general, share the same three objectives, in varying degrees. Most individuals want to: maintain or improve their lifestyle; transfer wealth to their heirs or to charity, and pay as little in taxes as possible.

The concept behind purpose-based construction is to build portfolios that target specific client goals rather than the usual approach of optimizing the risk/return trade-off of the overall portfolio, a statistical portfolio property that may or may not have any real meaning to the average investor.

For example, a portfolio might be “bucketed” to meet specific investor objectives such as:

• Lifestyle maintenance (the “stay rich” bucket),

• Market participation (the “cocktail party chatter” bucket”), and

• Aspirational wealth (the “get richer” bucket).

A different approach might be to present individual investments in the context of their specific purpose within the overall portfolio:

• Capital preservation and income,

• Market exposure-based growth,

• Inflation protection,

• Diversifiers, and

• High-risk growth.

It is worth noting that the underlying tenets of Modern Portfolio Theory are not discarded when implementing purpose-based portfolio construction. Risk, return, and diversification still matter, and the overall portfolio can still be optimized using traditional MPT inputs and outputs. The presentation of the portfolio, however, is designed to align with how investors think about their money (i.e., that the portfolio exists to fund specific objectives and individual strategies serve specific purposes).

Some practitioners of this approach advocate optimizing each sub-portfolio and then “rolling up” the sub-portfolios into an optimized overall portfolio. My belief is that is that the primary value of the exercise is optical, presenting the recommended portfolio in investor-centric ways, so optimizing at the overall portfolio level is sufficient, even if the corresponding sub-portfolios are not “optimized” on a stand-alone basis.

A quantitative variation on this theme is applying to individual investors the institutional investing concept of liability-driven investing. With institutional LDI, the future liabilities of the investor (pension fund, endowment, defined benefit plan, etc.) are forecasted and a portfolio is built that attempts to minimize the risk that the portfolio will not be able to meet its future funding obligations. Any surplus portfolio assets not required to “immunize” future liabilities can then be invested more aggressively to build the overall portfolio value.

Some advisers to individual investor portfolios are applying this concept. Future obligations or “liabilities” (retirement funding, education expenses, weddings or other “target date” events, etc.) are forecasted, and portfolios are then constructed to fund those liabilities, with any excess assets invested more aggressively for dynastic wealth or end-of-life charitable purposes.

Regardless of how it is applied, the purpose of objectives-based portfolio construction is to build and present portfolios in the way that individual investors actually think about their money, which is that different buckets of money have different specific purposes.

The belief is that this approach (a) helps investors understand better how they are invested and why, and (b) helps instill investor discipline, which is a critical component to long-term investment success.

This story is part of a 30-30 series on building a better portfolio.

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