This article describes our investment beliefs, relating to wealth and portfolios, that constitute the basis upon which strategic and tactical decisions are taken by Wren and its alliance firms, MdF Family Partners and WE Family offices. They are designed to ensure full alignment between the values and responsibilities of our employees and clients, and of the alliance firms.
Portfolio Investment Belief 1: The first and most important thing is to define the purpose of the wealth, and the timeframe over which goals need to be met
We believe the purpose of any wealth falls into one, or a combination, of three categories:
- stay rich
- get richer, or,
- enjoy the wealth.
For most clients, an element of all three are present but it is extremely important to define the relative importance and demands of each purpose. We categorise all assets in portfolios according to how they serve these goals, while trying to avoid having any one asset serving more than one of the above goals. Making sure this is agreed and understood with the client ensures the path we set out on is not deviated from at the worst possible time, which is often the case with irrational human behaviour, and can often lead to permanent capital destruction.
It is essential for clients to view their investments over a longer time frame. A longer view facilitates an emotional detachment and creates the intellectual space needed to make better decisions.
We believe that the real measure of success of a portfolio strategy is whether it meets the clients’ goals, which are more likely linked to beating inflation rather than performance relative to an arbitrary financial market based benchmark.
Portfolio Investment Belief 2: Strategic asset allocation is the dominant factor of risk and returns of any portfolio
At the outset of any mandate (be it advisory or discretionary), our senior staff from the client and investment teams will engage with the client to ensure that a full understanding of the risk tolerance, return objectives and liquidity demands (current or potential) required of the portfolio is reached.
In recommending an asset allocation, we will consider the requirements placed upon the portfolio in a well-defined and structured investment framework which is transparent and user-friendly. This process is the basis for our clients to fully understand the implications of their risk, return and liquidity preferences.
This process is revisited on a frequent basis (at least annually) to consider any changes to the client’s situation and review the portfolio parameters in order to validate or modify the strategic asset allocation.
A well-defined and understood asset allocation can assist in avoiding permanent losses of capital caused by knee jerk reactions to periods of poor performance. Through understanding the capacity of an asset allocation to fall short of expectations one can consider the actions to take ahead of time, and define alternative plans of action should the event occur, rather than making poor decisions in the heat of the moment.
Portfolio Investment Belief 3: When deciding on a strategic asset allocation, all of a client’s assets should be taken into account – properties and or unquoted stock – in combination with borrowings and other liabilities.
Our natural inclination and is to advise or manage all of our client’s financial assets. There is a good reason for this: only with a full picture of the purposes, needs and preferences, and overview of all assets and liabilities can advice be adequate. When we start working with a new family, charity or endowment:
- We always start by creating a strategic plan and a road map that treats wealth as an enterprise of its own
- We build a full picture of all assets and liabilities (formal borrowings as well as informal undertakings)
- We always refer back to the strategic plan and asset picture in order to maintain a full investment dialogue and reporting structure.
In the rare event that a family, charity or endowment asks us to advise or manage part of their wealth we need to be aware of the overall strategy and be satisfied that we both agree and understand our role within it.
Portfolio Investment Belief 4: Inflation is the first tax
Nobody can escape from the erosion of inflation. Inflation is important across all periods but it can be particularly harmful over long periods, given the effects of compounding. Some, if not all, of our clients and partners have inflation-sensitive liabilities or objectives, and in those cases our investment framework must be adjusted to deliver inflation sensitive returns.
Source: MdF Analysis
Portfolio Investment Belief 5: Diversification is the most sensible approach to preserving wealth over the long term
A well-diversified portfolio can reduce volatility without impairing returns. This can be achieved at the portfolio level, the asset class level and at the security level. Combining assets that are less correlated will result in less extreme portfolio swings. This is important when drawdowns occur because a client will be less likely to sell out at the bottom, thus avoiding permanent capital destruction.
Concentration is the fastest route to wealth creation, but the risks associated are significantly higher than a diversified approach.
Clients who wish to achieve both goals should clearly differentiate between assets held to preserve wealth and those whose goal it is to create wealth.
Portfolio Investment Belief 6: There are many dimensions of risk, volatility is only a part
It is important to look at risk both quantitatively and qualitatively. Volatility is a commonly used measure to think about the dispersion of outcomes from an allocation, this is most relevant for liquid investments where accurate price data is available at very frequent intervals. Many other quantitative measures are also important such as drawdown profile, correlation, and volumes traded.
While these measures are applicable to many investments we make for our clients, more qualitative risks are present in all allocations. These can’t be quantified but are equally important, if not more so. Some examples of these qualitative judgements include: counterparty risk, legal risks, key person risk, and risk of style drift.
Both these sources of risk must be monitored. It is tempting to track quantitative risks for liquid investments exclusively, but due attention must be given to softer, more qualitative risks to understand the characteristics of an entire portfolio.
Illiquidity is one of those other dimensions of risk. Illiquidity always deserves a premium, as the limitations to act or the high cost of exiting earlier are usually higher than commonly estimated, especially in periods of distress. Such a premium in certain cases may present an opportunity for certain portfolios, depending on their circumstances. We believe in taking appropriate illiquidity risk when such opportunities arise, but always understanding its implications for the overall portfolio.
Extreme care needs to be paid to not just evaluating illiquid portfolios on a volatility risk measure, as illiquidity tends to underestimate real volatility by having less frequent valuation and less frequent actual trading.
Portfolio Investment Belief 7: Leverage, while it has the potential to increase returns, is also a dangerous weapon
Special care needs to be exercised when dealing with leverage. This includes the degree of leverage, the investments it is associated with and how the portfolio may react to changes in asset values. Only in very special circumstances should a personal guarantee be granted.
Leverage analysis extends not only to explicit leverage, but when also it is imbedded within particular investments. When evaluating any investment proposal the most appropriate measure is Return on Capital Employed, not Return on Equity. Many financial products or investment proposals present high returns characteristics or expectations due to embedded leverage. In such cases, return figures are not comparable as risk levels are higher than in non-leveraged alternatives.
The uncertainty associated with leverage has a hidden cost – it reduces the effective time horizon of the investor as it may not be possible to ride out severe volatility and reduction in portfolio values.
One volatile moment may result in loss of control of the portfolio if the decline in value is significant enough to trigger repayment of the loan.
Portfolio Investment Belief 8: Simplicity is almost always preferable to Complexity
A complex structure implies higher costs of implementation – which are asset returns accruing to the manager instead of the client’s portfolio, and complexity is typically associated with less transparency and a potential opaqueness of all the risks which one is assuming when making the investment.
When approaching portfolio construction and investment strategies, all other factors being equal, we will prefer and recommend a simple solution to a complex one.
Portfolio Investment Belief 9: Fees and commissions eat return… or capital. And taxes matter
Total expenses of portfolio management (fees and commissions) are a significant component of total return and simultaneously lower returns and raise volatility. Keeping expenses low is an important part of the portfolio management process, however minimising portfolio costs may be detrimental to the return potential – and poor returns are the most dear costs.
Cost reduction may involve “collectivisation” of fixed costs through the use of funds and funds of funds for some asset classes, hedge funds, private equity and real estate for example, where money to be invested does not exceed a minimum economic threshold
Investors should also pay attention to the total cost of management. Frequently the true cost burden is not well disclosed, and it may be significantly higher than the published management charges. All efforts should therefore be made to fully uncover all the costs, fees and commissions associated with an investment opportunity.
Looking forward to the last of our portfolio beliefs, compounding is not only a return phenomenon, but it is also applicable to costs. Therefore this matter should be considered carefully when managing wealth for the long term.
When we make any investment decision it will be a considered balance of risk, return and cost. We will always require full transparency of the total cost to our clients or partners. If there is a performance fee arrangement it should align the interests of all the parties involved and be fair.
Finally we will always try to reduce cost, risk and complexity related to manager selection and oversight. Equally, we always focus on after tax return. But at the same time we want to be wary of investment decisions taken purely for tax reasons.
Portfolio Investment Belief 10: Compounding is the eighth wonder of the world
Einstein is rumoured to have described compound interest as “the most powerful force in the universe … and … He who understands it, earns it… he who doesn’t … pays it”. Warren Buffet has also become renowned for his use of compounding. The longer the time frame, the more important the power of compounding.
The impact of compounding is magnified for portfolios which are able to reinvest rather than withdraw income.
The chart below illustrates the effect of compounding in a portfolio of £100 which starts with an income of £2.50 growing with inflation at 2%; the overall portfolio value grows at an average rate of 5% yearly. So the £2.50 income received in year 1 and reinvested in the portfolio grows by 5% in year 2 along with the rest of the capital. By the end of the 20th year while the total value of the portfolio has increased from £100 to £390 (in nominal terms) the original capital of £100 is worth 26% of the total while income has accumulated to 17% and the cumulative effect of compounding on capital and reinvested income represents 58% of the portfolio’s total value