Optimal returns may not come easy

There has been a proliferation of investment services and products in the recent past prompting investors, especially high net-worth investors, to typically engage multiple wealth managers. This often leads to problems of exposure overlaps, as the wealth managers engaged by the investor are likely to follow similar investment style.

The question is: How should investors address this issue?

This article explains the issues of multimanager portfolio. It then shows how investors can create a tiered structure to optimally create such multimanager portfolio.

It is common for institutional investors to have multimanager portfolio. Such investors allocate money to various investment styles in each asset class. Indian investors primarily have multimanager — more than one manager — to reduce the risk associated with each manager.

Suppose an individual has Rs 50 lakh to invest. What if she engages a single asset manager who eventually underperforms? The investor would be more inclined to spread her assets among several managers to reduce the risk of underperformance of any one manager.

Such multimanager portfolio has its merits. For one, the underperformance of one may not significantly affect the master portfolio. Besides, the investor overcomes the need to clinically evaluate a portfolio management firm, which she would have to if it were the only firm she engages.

The flip side is that the master portfolio at the level of the investor may be inefficient because of overlapping manager styles. Importantly, the master portfolio may not be Markowitz-efficient. That is, the overall portfolio cannot provide optimal return for a given level of risk. The reason is because no wealth manager is aware of the overall risk of the master portfolio or the investor's overall risk tolerance level.

The question is: How can investors employ multimanager to create optimal master portfolio?

Investors typically suffer from several biases. Interest or dividend income, for instance, is not treated the same way as capital appreciation. The former is considered return on investment while the latter is treated as return of investment.

It therefore follows that interest and dividend income is meant for current consumption while capital appreciation is meant for the future consumption.

Psychologists term this behaviour Mental Accounting- segregating cash flows into various mental accounts such as current income (dividend) and future income (capital appreciation).

We believe individuals can adapt to mental accounting bias by mapping their wealth needs through multimanager portfolio.

How? Every individual has three macro-level wealth needs- liquidity, current income and growth. And when these wealth needs are mapped to an individual's investment lifecycle, it translates into Protection Assets, Lifestyle Assets and Aspiration Assets.

Now, Protection Assets are essentially meant to provide an individual with basic standard of living. This portfolio requires investment in cash equivalents and insurance contracts. Lifestyle Assets are meant to help the individual maintain her lifestyle. This requires investing primarily in passive equity investments such as ETFs and Index Funds besides fixed-income products to balance the overall volatility of the portfolio.

Both Protection Assets and Lifestyle Assets can be created using mutual fund products.

Individuals should actively seek out wealth managers for Aspiration Assets. Such assets enable an individual to enhance her lifestyle.

This requires investment in assets that generate either absolute returns or excess returns over the benchmark index.

Wealth managers can achieve this by following investment styles that mutual funds do not offer. This would involve strategies such as merger arbitrage and statistical/quantitative trading.

Conclusion

Investors should engage wealth managers who follow visible and distinct investment styles.

Importantly, they would do well to avoid those wealth managers who do not have an investment philosophy but simply choose to invest to “generate capital appreciation”.

A well crafted multimanager portfolio for Aspiration Assets along with mutual funds for Protection Assets and Lifestyle Assets could roll-up into optimal master portfolio.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at > enhancek@gmail.com)

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