Copyright 2010 ProQuest Information and LearningAll Rights ReservedCopyright 2010 New York State Society of Certified Public Accountants The CPA Journal
FINANCE: MARKETS & INVESTMENTS; Pg. 48 Vol. 80 No. 1 ISSN: 0732-8435
Overseeing Investment Managers
Jesse Mac key is the president of National Network of Accountants Investment Advisors Inc. (NNAlA).
CPAs are often called upon to advise individuals on investments, and even CPAs who are not investment specialists have long guided clients toward sound investment approaches and away from deals too good to be true. CPAs are often asked by clients to monitor various tax and other aspects of their investment portfolios. As the crisis continues to develop, pearls of investment planning wisdom have begun to surface. It’s useful to explore 10 of these lessons, so that CPAs may more readily identify the forward-looking investment managers who are applying them. Here are some of the ten lessons from the financial crisis: 1. Combine sound investment planning with asset-liability matching. 2. Reassess regularly and whenever major market events occur. 3. Understand and control risk, especially when due diligence is difficult. 4. Utilize variable annuities and other guaranteed products where appropriate. 5. Use individual issues held to maturity for a portion of the fixed-income portfolio. FULL TEXT
10 Lessons from the Financial Crisis
CPAs are often called upon to advise individuals on investments, and even CPAs who are not investment specialists have long guided clients toward sound investment approaches and away from deals too good to be true. CPAs are often asked by clients to monitor various tax and other aspects of their investment portfolios. When serving as an executor or trustee, a CPA must directly oversee the activities of investment advisors. For most executors and trustees, the old prudent safe harbor of U.S. Treasury securities is no longer available. Today, fiduciaries are generally required by law to use asset aUocation and diversification strategies derived from modern portfolio theory (MPT).
Over the past two decades, a growing number of CPAs have become directly involved in managing investment assets for thents. More often, CPAs continue to work with, monitor, and oversee the activities of outside investment professionals. Therefore, the abUity of CPAs to help identify traits of competent investment managers – and to eLiminate those who lack them – has grown in importance.
The recent financial crisis has provided a unique proving ground. As the crisis continues to develop, pearls of investment planning wisdom have begun to surface. It’s useful to explore 10 of these lessons, so that CPAs may more readily identify the forward-looking investment managers who are applying them.
One of the most important services that investment professionals can provide is to ensure that individuals achieve their longterm goals regardless of fluctuations in the economic environment. Prior to the crisis, many investment advisors were not paying proper attention to the concepts discussed below. Those investment advisors who have paid attention will likely continue to provide sound investment advice, both to clients and to CPAs in their fiduciary capacity, while those who have failed to do so may no longer be standing when the economic tidal wave finally recedes.
This article is accompanied by a brief checkhst (Sidebar) CPAs can use to help evaluate whether an investment advisor is following sound investment approaches, properly servicing clients, and appropriately managing the trust and estate investments the CPA oversees.
1. Combine sound investment planning with asset-liability matching. The practice of following sound investment planning principles is all too rare in the investment management world. The related process of mapping out a sensible investment plan is often foreign to the investing public, who typically try to seek out the “best” investment managers, funds, securities, or other investments, with little understanding of the due diligence necessary to find them, thereby substantially decreasing the likelihood that they actually will. This lack of understanding tends to lead investors to advisors lacking the necessary competence, or to advisors who put their own financial interest ahead of that of their clients. For many individuals, CPAs can play an important role in finding investment advisors who use sound investment approaches based on specific risk tolerance, net worth, family situation, and other life circumstances.
Without the right professional aid to properly determine client goals, assess risks, determine cash flow needs and constraints, assess client suitability, and customize an action plan to achieve goals, the probability of client satisfaction and the achievement of investment goals in the long run is generally low. CPAs possess the unique professional skills, along with unmatched specific client knowledge and understanding, to provide this professional support.
When lacking such support, investors are typically left without a clear definition of their objectives and a plan to reach them. This inevitably causes them to be disenchanted with their portfolio performance, because tiiey have no basis on which to judge whetiier their finances will be able to recover in the long term. All they see is the short-run situation, which, in the case of 2008-2009, was mainly their portfolio dropping like a rock. The resulting feeling of helplessness can be rninimized if a sound plan of action is in place and competent advisors are providing die necessary support, so that a proper determination can be made as to what is required to recover from the fall.
All too often, investment managers seek to maximize performance as a goal in and of itself, without reference to an individual’s overall financial objectives. If such objectives can be met with conservative investment returns, it is wise to explore the benefits of a reduced-risk approach, rather than taking on what may be unnecessary risk. The probability that a well-defined investment plan aligned with individual objectives will be fulfilled can be increased by the use of direct asset-liability matching. This involves piecing together an investment plan so that each risk to the achievement of a certain objective is directly offset by a corresponding asset or risk management technique. The more direct the match, the greater the likelihood of achieving the client’s goal.
For example, if it is determined during a financial planning analysis that an individual currendy has enough monetary assets on a nominal basis to launch a business in five years, but needs to hedge against inflation risk, it may be more prudent to compose a directly matched portfolio of Treasury Inflation-Protected Securities (TIPS) rather than a stock/bond portfolio. In this case, die client would nearly eliminate the five-year inflation risk, preserve the principal on a real basis, and also take stock/bond market volatility out of the equation. With this more direct match, even if the TIPS decrease in value and the stock market drops precipitously, the client’s goal (purchase of the assets needed to start the business) will still be achieved, as tile price of the needed assets will theoretically also have dropped with the TEPS. This assetliability matching principle can be applied in many forms when creating an investment plan. It is important to question investment managers about their use of such matching techniques.
2. Reassess regularly and whenever major market events occur. Given the havoc that the financial crisis continues to wreak throughout the economy, many investors have been dramatically affected beyond the drops in their portfolio values. Business owners should be given special consideration in this regard. Witii dramatic changes in cash flow needs, it has become ever more important to reassess the objectives toward which portfoüos are intended, and reexamine whether the assets in a portfolio are properly allocated to meet those objectives. For example, as business earnings and reserves decline, business owners may be unexpectedly forced to liquidate portfolio holdings in order to meet cash flow needs. As such, their portfoUo investment time horizon may be shortened dramatically and it may be necessary to reallocate the portfolio on a much more conservative basis.
During the last months of 2008 and die first few months of 2009, it was extremely important for investment advisors to contact all clients to reassess such factors as their life situation, portfolio investment time horizons, liquidity, income needs, and risk tolerance to ensure that a proper portfolio allocation was in place and that clients were not taking on any unnecessary risks. CPAs should be proactive in assessing whether clients are working with investment advisors who actively discuss diese matters, in order to recommend necessary adjustments.
Opportunistic portfolio rebalancing also became increasingly important as stocks generally lost value faster than bonds, leaving portfolios bond-heavy. During the rapid short-term market recovery period from March to May, an unintentional dearth of stock exposure due to a lack of rebalancing left such portfolios unable to proportionally regain the losses they had experienced. Therefore, it became clear that, in addition to regular annual or semiannual rebalancing, active and opportunistic rebalancing was needed.
3. Understand and control risk, especially when due diligence is difficult. Ln the wake of the Madoff scandal, there could not be a clearer lesson than the importance of independent investment due diligence. The lack of information available with regard to the one-page fabricated statements that Madoff supplied to his “investors” lends credence to Warren Buffett’ s tenet that one should not invest in something that one does not understand. Even sophisticated investors learned that friendship and trust (unfortunately misplaced) should not be blindly put in front of sound investment due diligence.
In reality, there are certain types of investments where performing due diligence is difficult, or even impossible, for all but the largest institutional investors. Such investments include hedge funds and other investment entities that claim to be successful due to proprietary methodologies developed by PhDs. Without similar credentials, complete due diligence would be beyond even the most sophisticated investors.
There are, however, a reasonable number of hedge funds and investment groups with proprietary practices that have honestly delivered superior returns over the long term for their high level of risk, in the recent crisis, some of them have experienced serious reverses, while others, which shorted declining markets at the right time, have produced outsized gains. Unfortunately, the practices of some entities rely on smoke and mirrors, or in the case of Madoff, outright fraud.
The first lesson is to perform as much due diligence as is reasonably possible. Even small steps – such as checking to see if Madoff s auditor was peer reviewed and had sufficient expertise and independence^ – can go a long way. Some investment advisors and CPAs did take such steps and helped keep their clients out of the Madoff orbit. Reliance solely on securities regulators or the due diligence of third-party organizations proved to be a mistake. As much due diligence as is reasonably possible should be performed at inception, and regularly thereafter by the overlay portfolio management firm and advisor, simply to ensure cohesion with the investment plan and expectations for future performance. CPAs and their ctients would do well to ascertain that such due dibgence is being performed on an ongoing basis.
A second lesson is to keep the amount invested with any single advisor or firm reasonable with respect to the client’s total investable assets and risk tolerance. To avoid potentially unknowingly investing with a fraudulent organization, it is important to disperse investment portfoUos among a reasonable number of investment firms and custodians, based on the amount of investable assets. This is necessarily a matter of judgment. In some cases, investing an excessive amount with one firm may be necessary to secure certain levels of thent service. For example, some private banks or family offices may require minimums of anywhere from $2 million to $50 million. The greater die percentage of a client’s net worth that is invested with a single firm, the more due diligence is necessary. When excessive amounts are invested with one firm, it is helpful if it is a public company, where extensive public information about the company, its financial condition, and its management are readily available.
4. Utilize variable annuities and other guaranteed products where appropriate. “Long Derided, This Investment Now Looks Wise,” was the headline in a July 24, 2009, WaU Street Journal story about investment products with insurance wrappers, such as variable annuities (VA) with guaranteed income Uving benefit riders. When properly structured for the right thent such solutions have proved to be “important tools for minimizing the risk associated with retiring during a down market.
This “point of retirement” risk is mitigated by the ability of such products to provide a guaranteed growth of income benefit amount regardless of the market performance of the underlying mutual fund subaccounts. Investors who purchased such products prior to the 2008-2009 market debacle may now have the ability to retire as planned, whereas their counterparts who avoided them may need to postpone retirement for several years in order to achieve the standard of living they would like, and, in some cases, may never be able to retire.
Unfortunately, many VAs with the best terms are no longer avaUable, due to strong demand and the need for issuing insurance companies to ensure adequate reserves to provide benefits. Currently available VA products can still be extremely useful to individuals who have already experienced significant losses, in that the guaranteed growth of benefit amounts provides a hedge against long-term market underperformance (an increasingly possible scenario) for future income purposes.
5. Use individual issues held to maturity for a portion of the fixed-income portfolio. Different investment vehicles that provide exposure to the same asset class may perform differently under the same market conditions. Bonds are an excellent example. When individual fixed-income securities are purchased and held to maturity, die degree of risk related to interim interest rate fluctuation and bond market price movement is minimized. This is because an investor knows for certain the amount invested, the coupon and yield amounts, and die amount of principal to be received if the asset is held to maturity. Interest rate risk can be reduced by me utilization of bond ladders, where bonds mature in successive years. Because issuer credit risk remains, diversification remains important.
When bonds are purchased through mutual funds (instead of being individually purchased), diversification can be readUy achieved. But bond fund managers often engage in active trading to generate alpha, that is, performance above a standard benchmark index used for that type of investment. For many, this was a significant problem in the past year, as there was Uttle abiUty to generate alpha in the crisis market environment. In fact, alpha was negative in many instances.
In the crisis market of 2008-2009, those who held individual issues to maturity were provided with the inherent issuer guarantee of return of par value and coupon payments (provided the issues were held to maturity), while those who used only actively traded borni funds were subject to significant portfoho losses. This does not mean that investors should pursue an individual securities-only portfoho – especially if they do not have a large amount to invest as they will not be able to achieve the diversification necessary to sufficiently reduce issuer credit risk. When working with a large enough portfolio, the optimum solution is to build the majority of the fixed-income portion of a portfolio with individual issues, and build the remainder with weakly correlated fixed-income types (such as international bonds, floating rate securities, and government agencies) using mutual funds and ETFs. This results in a portfoho with a relatively predictable target risk/return and yield and diversification by number of securities as well as type of securities.
6. Consider the cash value of life insurance as an asset class. One asset class that has gone wholly neglected by many investment managers is the cash value of life insurance in whole life or universal life insurance policies. While such life insurance Ls not an investment once purchased it can be managed as part of an investment portfolio. There is growing empirical evidence that when properly managed, owning such insurance from quality companies can decrease risk and increase return in a portfolio. In addition to the potential death benefits, such cash value serves as an additional noncorrelated asset class. Policyholders who held a significant portion of their assets in cash value life insurance did not see the rapid decreases in overall portfolio value that stock and bond investors did during the crisis. Life insurance cash value is an excellent conservative complement to stock/bond/altemative portfolios and can outperform other asset classes in certain circumstances.
7. Soundly utilize multi-philosophy investing. There are several investment philosophies presently in vogue and several variations on each philosophy. Each is right for some investors, but none is right for all. Many of the philosophies are rooted in modem portfolio theory. As originally described by Nobel laureate Harry Markowitz, MPT emphasizes strict buyand-hold strategic asset allocation and diversification, using various noncorrelated asset classes and investment-style component holdings. The goal is to minimize the risk undertaken for a given target rate of return or to maximize the return for a given target risk tolerance.
Within an overall MPT methodology, there is an opportunity to add an additional layer of diversification through multiphilosophy investing, which includes such alternatives as tactical, absolute return, or opportunistic components. Such alternatives can yield positive results on a shortterm basis as compared to a strategic-only style, but they carry additional risk as well. Beyond these, there are other modifications to traditional MPT that can be applied if one sees it as an evolving theory or sees markets as adaptable. An increasing number of portfolio management theorists now make various assertions as to the “inefficiency,” “reflexivity,” or “adaptive” nature of markets. Such ideas, rooted in behavioral economics, are quickly gaining adherence in academic and industry circles, largely as a result of the financial crisis. If they are correct, there is more potential benefit to the active management of a portfolio than the dominant efficient-markets hypothesis would lead one to believe.
An in-depth discussion of these philosophies is beyond the scope of this article. The important point to remember is that some investment advisors and firms are philosophically flexible and some are locked into just one or two approaches. It is vital that investors ask the right questions, to make sure they are working with advisors who use approaches best suited to their circumstances and risk tolerance.
8. Retain the ability to include short or long/short funds within an asset allocation. During the fiercely negative performance of the markets from September 2008 through March 2009, virtually none of the longonly equity asset classes posted any positive performance or even reduced capital losses. The only stock investment tactic that would have theoretically been able to show positive returns in such an environment is shorting. For portfolios without exposure to any type of long/short strategy or manager, there was little opportunity to capitalize on the rapidly disintegrating markets in 2008. While exposures to long/short strategies are generally low in an institutional-style portfolio, even a 2% to 5% allocation to such a manager can prove beneficial to reducing portfolio risk in the long term and could reduce the negative effects on portfolios in the short term.
The downside is political risk, which was evidenced in 2008 when the SEC banned short selling for a period of time.
9. Maximize tax loss harvesting. A key element of long-term investment success, and one where CPAs play a key role, is maximizing the benefits of capital and other tax losses. One of the small consolations afforded to investors in 2008 and 2009 was the ability to harvest tax losses from their portfolios. This enabled them to offset gains where possible, to claim the maximum $3,000 capital loss on their tax reoirns, or to carry the balance forward for ase in future years.
It is imperative that when opportunities such as the recent bear market (with nearly every portfolio showing a loss) present themselves, investment managers and CPAs provide an added layer of planning to reduce clients’ tax bills.
10. Stay in regular contact with clients. Perhaps the most valuable lesson of this financial crisis has been the vital importance of investment advisors staying in frequent contact with clients. Keeping them informed about the markets, their rx)rtfolios, and how their investment plans are being affected have been paramount to client retention. The clearest trend to emerge out of the past year is that clients who are not properly serviced will inevitably leave to find an advisor who does communicate well, even if it means sacrificing portfolio performance, which, somewhat surprisingly, many clients seem to view as secondary.
When asked why they are changing investihent advisors, the most common response is, “I haven’t heard from my current advisor in – weeks/months/years.” CPAs can provide a major service to clients just by asking if they regularly have discussions with their investment advisor.
A Vital Role
The ability of investors to achieve life goals is increasingly related to the soundness of their investment plans. CPAs have a vital role to play in the process, helping clients develop and monitor these plans and guiding them toward prudent investing approaches and the competent investment professionals who employ them. Playing this role helps CPAs both maintain their service relevance and farther cement long-term client relationships. SIDEBAR
INVESTMENT PLAN/PORTFOLIO CHECKLIST
* Formalized investment plan has been developed and implemented.
* Investment policy statement and asset allocation guidelines are in place as appropriate for client risk tolerance, financial goals, and life circumstances.
* Investment assets are properly matched to liabilities and congruent with client goals.
* Investment advisor/firm communicates with client at least quarterly to reassess portfolio suitability.
* Investment advisor/firm contacts client in timely manner, whenever special portfolio events warrant
* Investment advisor/firm performs independent research and due diligence.
* Variable annuity and similar guaranteed products are used when appropriate.
* Fixed-income portfolios of $100,000 or more use primarily individual issues.
* Insurable clients have an appropriate amount of cash value life insurance.
* A significant portion of the portfolio utilizes MPT-based strategic asset allocation.
* Alternative philosophies are used, where appropriate (absolute return, tactical, opportunistic, etc.).
* Portfolio retains the ability to include short or long/short funds and managers.
* Investment advisor/firm performs annual tax loss harvesting on the portfolio.
* To help protect against fraud and defaults, sufficient investment advisors and firms are retained for total amount of client investable assets.
January 26, 2010