How to protect a client's portfolio in uncertain times

This article was originally published on FT Adviser. Read the article here.

While all investors naturally want their assets to be safe, the issue becomes imperative for wealthier private clients. Those with greater assets frequently prioritise protecting their wealth over taking on risk to maximise their returns.

Recent research showed that 75 per cent of high-net-worth (HNW) individuals see future-proofing their wealth as more important than ever, while conserving assets for their future was the top investment goal [1]. For this group, preserving their lifestyle and passing on wealth to the next generation is key, but both are goals that can become more challenging in adverse market conditions

Reintroducing risk as uncertainty grips the global economy

In a world of benign economic growth, and with asset prices buoyed by quantitative easing and low interest rates, a rising tide lifted all ships. That has certainly been seen by many HNW investors since the financial crisis.

For many, with the yield curve depressed, the temptation may have been to take on more risk, without necessarily suffering the pain or volatility that higher risk can bring in times of more normal monetary policy. However, in uncertain geopolitical conditions, the risk/performance balance is not the only part of the equation.

As the economic cycle shifts, investors’ concerns over their assets, and their exposure to loss, will no doubt be heightened. This sheds light on another indeterminate aspect of futureproofing assets: succession planning. As such, it is important that investor portfolios reflect not only risk appetite but also a wider approach based on legacy and wealth transfer – especially if protecting their wealth is a key priority.

Warning lights have been flashing across the global economy in 2019. Many of these have been triggered by political instability and policy decisions from the governments of the world’s largest economies. The escalating trade war between the largest of them all, China and the US, for example, is still dragging on the global economy. In fact, the OECD has predicted that global growth in 2019 will be the lowest in a decade[2], citing trade conflicts as a core risk. China’s economic growth continues to slow, the recent outbreak of Coronavirus adding complexity and anxiety. Last but not least, the inverted yield curve in the US, seen for the first time since 2007, is thought to be an indication of a downturn.

While five years of relative political stability are now forecast for the UK, the recent volatile, political chaos is still on people’s minds. Furthermore, the uncertainty around the future trading relationship negotiations over the course of 2020, and the lasting impact on the economy and wealth management industry of the country’s departure from the European Union is another cloud on the horizon. This causes disruption on both sides of the Channel, at a time when there are already concerns over their respective health.

This is bringing precariousness.

Remember the S&P 500 plunged by nearly 7 per cent last year from the first week of May to the first week of June, before recovering strongly. In the UK, the FTSE 100 saw its value fall by 5 per cent last August, the biggest monthly drop in nearly a year, and a whisker away from its worst losses in four years[3].

Central banks have not stood still as risks rise. Monetary policy is becoming more accommodative. In the US, the Federal Reserve has moved to cut interest rates twice in 2019, while the ECB cut its bank deposit rate to an unprecedented -0.5%, and has resumed quantitative easing to stimulate growth.

The flipside to this action is that yield remains hard to find, especially in fixed income assets. When we consider the impact that inflation has on eroding returns, negative yield in these types of assets can pose a significant problem for HNWs looking for income to support their lifestyles, and yet manage their risk appropriately.

The same is true with cash; a natural reaction to market instability might be to allow the cash balance of a portfolio to drift up significantly. However, with savings rates often lower than inflation, this will also see assets dwindle in real terms in the long-term.

Against this backdrop of uncertainty and change, it is important that HNW investors are not complacent. It is crucial to ensure they have the right investment strategies in place that will perform through periods of turbulence as well as through the good times, while also protecting their portfolio against inflation. It is vital that they pay particular attention to their succession planning strategies, in order to ensure their wealth is best placed to grow whilst also being protected and preserved for future generations.

Diversification delivers a smoother ride for investors

Not placing all your eggs in one basket is one of the most heavily cited adages in investment, but it is all the more pertinent at present as investors look to manage risk. Diversification is a core part of modern portfolio theory; by investing in a variety of assets, high net worth investors should be less exposed should one particular sector, country or asset class bear the brunt of a downturn.

A broad range of assets should also help reduce volatility of annual returns, providing a smoother road for investors in times of upheaval in the financial markets. This is extremely important for HNW investors that frequently sell down their holdings to fund their lifestyle, meaning they are less likely to sell during a pronounced dip in capital value.

This diversification could include non-correlated assets, whether bonds, commodities or alternatives such as property and private equity. In theory, these would react differently to market movements, again, smoothing volatility and avoiding excessive risk concentrations. However, alternative strategies are often less liquid, meaning a high net worth investor’s investment horizon should be considered before taking the plunge.

A global perspective

Diversification should not just be limited to asset classes, however. HNW investors should ensure their portfolios have a global perspective. If we look at equities, given the international nature of the world’s largest companies, investors may think that their exposure to large, domestically-listed companies already provides good global diversification. You only have to look at Shell, BP, and HSBC in the FTSE 100, for instance to understand the sheer amount of revenues that are generated overseas.

However, in staying close to home, investors may miss out on the best-in-class companies listed in other countries, and could have a less diversified sector exposure than a global portfolio allows. Furthermore, global diversity allows investors to hedge against localised economic or political events that will hit investment performance. This, again reduces volatility in returns.

Dividend payments

Dividends are a key weapon in an investor’s long-term investment arsenal.
For HNWs living off the natural yield of their investments, the income being delivered by stocks and shares is especially important, with bond yields at historic lows. In the UK for instance, while UK 10-year gilt yields stood at just 0.69 per cent in the second quarter of 2019, yields on UK-listed equities stood at 4.2 per cent[4]. And while income from a bond will not increase over its life cycle, the same is not true of dividend payments from companies.

The importance of dividends is not just limited to those seeking an income – but also affects those seeking to preserve and grow their capital. The income can provide something of a cushion should the underlying stock price fall – important if capital appreciation is less likely in times of market turbulence.

Moreover, dividends account for a very large proportion of equity returns. Research by Schroders, for instance, highlights that investors in MSCI World would have seen capital growth of 323 per cent over a 25-year period without dividends. However, the compounded growth of reinvested dividends brings turbocharged returns of 640 per cent[5].

The succession planning imperative

Defining the best and most efficient way to futureproof wealth and transfer it to the next generation is becoming increasingly complex, as family situations become even more diverse and internationally spread out. Inheritance and succession planning must be the top priority for high and ultra-high net worth individuals when seeking financial planning support to protect their assets.

At the same time as a growing uncertainty is generating a plethora of challenges, an increasingly complex regulations and tax legislations across multiple jurisdictions makes it imperative to seek expert advice and localised knowledge.

Furthermore, the rising scrutiny on tax avoidance schemes calls for more flexible and transparent solutions. In this respect, insurance-based wealth planning solutions can give wealthy individuals a comprehensive means of structuring their wealth.

Investing assets via a unit-linked life assurance solution provides the flexibility to invest in non-traditional assets, and benefit from deferred tax treatment, portability, asset protection and to appoint beneficiaries.

It is also suited for families who live and operate across a number of regions, ensuring that they can maximise cost and tax efficiencies.

Calmness without complacency

As global financial markets react to increasing geopolitical uncertainty and a decelerating global economy, high net worth investors should avoid knee-jerk decisions. However, changing conditions provide the opportunity to take stock with their advisers, and ensure their investment approach, as well as their succession plans, are still fit for purpose.

Is their portfolio sufficiently diversified?

Are they exposed to risk in direct appropriate correlation with their circumstances?

Are their wealth plans tailored and flexible enough to protect their assets while catering to their international lifestyles and family needs whilst making sure their assets will be efficiently passed on to the next generation?

Being able to answer these questions will give HNW investors peace of mind, as well as making sure their portfolios are primed for the choppier waters we may face.