Editor’s Letter

The current investment environment poses unusual challenges for many families. Whether one looks at political processes or the state of economic growth around the world, it is hard not to conclude that the “norm,” as it seems to be as we speak, is very different from past experience.

Economically, growth has been substantially subpar pretty much throughout the developed world, and many emerging countries are also experiencing a challenging economic time. While slow growth, in and of itself, would not necessarily be a major problem (for instance, if it were simply a part of a synchronized cyclical downturn), it is quite a bit more concerning when one observes that it is occurring against a background of highly unusual monetary and fiscal policies. The economic policy debate that started between Hayek—so-called classical economics—and Keynes—so-called Keynesian economics—and has been carried out by successive proxies since their deaths has continued; there seems to be increasingly minimal common ground among those various proxies. Increasingly politicized commentators and practitioners, plus a disease of the time that fails to differentiate between facts and opinions, make it practically impossible to evaluate policy with a relatively dispassionate and objective discourse. Adding to the confusion, the trend of public pronouncements that are focused on sound bites rather than true argumentation creates an environment that makes it quite hard for investors to know where to go and who or what to believe.

In practice, a decision by many of the developed world’s central bankers to embark on an experimentation that has seen an unprecedented accumulation of excess liquidity has led to equally unprecedented and abnormally low levels for interest rates. Understandably, equity price-to-earnings ratios have moved upward, (as they are the inverse of the earnings yield that should bear some relationship with the local interest rate structure), while real asset prices have often also gone up substantially. After all, excess liquidity has to find a home! That these have failed to trigger either a burst of economic growth or the onset of inflation must be a clear indication that prevailing global conditions are particularly adverse to growth; are these structural or cyclical? Whether this reflects regulatory or fiscal policy stances or some broader development is quite a bit beyond our point. Yet the distortions this may be causing in the real economy are quite real.

Similarly, a global tendency, at least within the United States and European areas and arguably even more broadly, for self-appointed elites to become disconnected from their countries’ broader citizenry is creating an environment where voters act more out of anger than their own self-interest. Admittedly, one could argue that individuals do not willingly forgo their self-interest, but are not well-informed. Yet, the anger that is definitely present is readily exploited by politicians, who quickly call upon one of the two most prevalent human instincts, nationalism or envy. With a superficial and polarized press that does not require answers to real questions, fanning populist flames leads to increasingly unstable political layouts and unpredictable election results.

Not surprisingly, this is causing greater-than-usual volatility in markets, and a measure of disconnect between fundamentals and prices, as just suggested. Capital markets are indeed primarily meant to offer a means of financing the real economy by allocating capital where returns appear the most appealing in risk-adjusted terms. These are usually determined by a mix of corporate and macroeconomic fundamentals, which makes them if not accurately predictable in the short term, at least reasonably understandable over a longer-term time frame. Without that role, capital markets become little more than glorified casinos, providing better returns for traders than investors, and potentially discrediting finance and its participants in the eyes of a broad public that feels it cannot come along for the ride. The risk that popular anger will be further extended to include finance is not only obvious, but in fact already in place in a few European countries. What this does to free-market economics in the long term cannot really be assessed in any reasonable fashion, but is an additional risk that investors must incorporate into the decision-making process.

Enter the cautious and honest long-term investor, who has no desire to gamble, but rather seeks to achieve some set of goals with differing time horizons under some degree of urgency. To characterize this problem as entirely and uniquely objective certainly overstates the case; yet it must be a fact that addressing the challenge still requires some degree of rigor and objectivity. Any such objective process must rely on some form of quantified capital market expectations and a somewhat rigorous approach. The twin disconnects to which we just alluded make such an endeavor particularly difficult, on two different grounds:

• 1. With an extended period of “abnormal” capital market circumstances, it is excruciatingly hard to develop and have confidence in any set of capital market assumptions. To what extent is the current environment a perversion of some norm based on long-term economic and finance theories? Or is it really some “new normal?” If so, how can that new normal be modeled?

• 2. With such a clear disconnect between the traditional norm and current market results, does it make sense to create a long-term investment policy based on assumptions in which confidence is not very high? Why bother? Why not attempt to time markets?

Those questions unfortunately make life very hard for investors. Quite a few feel they have lost out relative to those who were less rigorous and less serious. They feel betrayed. And at times, they simply allow themselves to be convinced by advisers who take advantage of one or another lucky recent decision to tout “special abilities or insights.”

In my view, the real solution lies in three broad elements that are difficult to put into practice:

• 1. Resist falling for the siren’s song touting a new normal. While a new normal might eventually come about, claiming such a “new paradigm” has long been the refuge of those who fail to take a long enough view, or who simply extrapolate the recent past into the indefinite future. Behavioral finance calls this “narrow framing.”

• 2. Design an investment policy based on your own goals, using capital market assumptions that still reflect the broad structures and relationships that have prevailed for the long term. Be prepared to revisit certain assumptions as times require, and note that the current uncertainty around the inputs into the modeling process requires humility with respect to trusting the output.

• 3. Decide whether to manage portfolios passively relative to that policy or to accept tilts away from the most egregiously valued asset classes or strategy, Consider (a) your sense of your ability to assess value successfully, (b) your perception of your capability to withstand returns that are potentially significantly different from those of “the market” for a while and (c) the reality of your specific tax circumstances and the nature and life of your holding vehicles as and when relevant.

In short, it is indeed a difficult time. This is probably not the moment to try to reinvent the wheel or side with advisers whose perspective and experience of history is measured in months rather than decades.

The Fall 2016 issue of The Journal of Wealth Management is quite diversified, although there is a special focus on asset allocation questions.

The first two articles illustrate an important dimension of the fact that wealth management involves multiple disciplines. They cover two crucial interactions between investment management and two other dimensions of the wealth management process: income and capital gain tax-efficiency and effective transfers of assets across generations. The first, by Stuart Lucas and Alejandro Sanz, starts with the observation that a low-cost, low-turnover, equity-oriented strategy with broad, consistent exposure to the market is the most likely to succeed over long periods, and suggests that the power of this simple approach lies in the interaction of investment strategy, tax management, and long-term compounding. The second, by Todd Retzlaff, presents a strategy utilizing asset-or-nothing calls to enhance the average wealth transfer of a GRAT from a grantor to a grantee—and indeed to improve the likelihood that the GRAT transfers any wealth at all.

The next five articles relate to asset allocation issues from a number of different points of views. The first, by Franklin Parker, explores the roles of time in the erosion of loss-tolerance of a goal-based investment portfolio; dubbing this phenomenon goal-based “theta risk,” the article discusses two techniques for defending the erosion of loss tolerance and some implications illuminated by these techniques. The second, by Jürgen Vandenbroucke, develops a framework to select financial investment products along the dimensions of return, risk, and loss, focusing on the fact that those investment strategies that seem to make the most sense express asymmetric return ambitions in their investment policy.

The third article, also by Franklin Parker (from memory, this is only the second time in the 18-year life of JWM that we publish two articles by the same author in the same issue, but we felt this exception was worth it here), illustrates the deficiencies of using only modern portfolio theory (MPT) metrics and assumptions when selecting portfolios in a goal-based setting. It suggests that goals-based practitioners need to factor in other variables, such as time to a goal and maximum loss thresholds when managing a portfolio to a goal oriented mandate. The fourth, by Lujer Santacruz, seeks to identify any dichotomy between theory and practice of asset allocation in the Australian investment management industry. It observes that although there is a high level of awareness, there is a low level of usage of asset allocation theory and theory-based methods in the industry, and recommends that the interaction between academia and industry be improved.

Our last article in this group is quite different, in that it is more tactical. Authored by Carlos A. Colón-De-Armas and Javier Rodríguez, it looks at the impact of U.S. presidential elections on the asset allocation of individual investors. It concludes that between 1989 and 2012, investors allocated more of their investment portfolios to stocks when a Democrat presided than when a Republican was in office, and that their equity exposure was higher during the last two years of a president’s term in office than during the first two years.

Our next two articles, though totally different from each other, both focus on some aspect of the stock selection issue. The first, by James Chong and Michael Phillips, starts with the observation that socially conscious individual investors face a host of challenges, including a stock buy list screened by environmental, social, and governance criteria, and investment strategies that are easily implementable. It concludes that strategies involving low-volatility investing, mean-variance optimization, and equally weighted approaches offer useful potential, particularly when an additional tool is added: an innovative method for estimating the return premium due to survivorship bias. The second article, by Daniel Ziggel and Christian Armbruester, focuses on the construction of a passive global equity market portfolio from the perspective of a multi generational family office, and describes the logical sequence of events, the methodology, and the thinking that drove the authors to arrive organically at an allocation and rebalancing algorithm from a multigenerational viewpoint.

Last but not least is an article by frequent contributor John Haslem, who here discusses the two major questions in determining whether mutual fund bundling services under soft-dollar arrangements benefit shareholders—and suggests that shareholder assets often are wasted through the use of soft-dollar arrangements.

Jean L.P. Brunel

Editor

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