Business | Opinion
How to be first in returns at difficult investment times
Building wealth in this decade is much harder than it was in the 1980s and the 1990s and it includes more disciplines.
- By Lauren Foster, Financial Times
- Published: 23:24 July 26, 2008
alpha/n. returns that are not correlated to the market.
This is the definition that most often comes to mind when investors think about alpha. But at one private bank, the term has come to mean a lot more.
"You need multiple sources of alpha to sustain your wealth in this decade," says Catherine Keating, chief executive of JPMorgan's US private bank. "Of course you need investment alpha, beta is not enough, you need to have alpha from having good managers, and smart asset allocation, but that's only one of the financial disciplines: your portfolio. You need to focus on liquidity, leverage and estate planning and you need to eke out alpha in every single one of those disciplines."
The quest for alpha has intensified because building wealth in this decade is much harder than it was in the 1980s and the 1990s - especially for US investors who have traditionally held a lot of domestic stocks in their portfolios.
"In 2008, with the sort of returns we have seen this decade, which have worsened in the last year, every wealthy family is focusing on 'how do I increase my returns?' and 'what's the prudent way to go about it and how are other successful families doing it?'," says Keating. "If you [focus on alpha], you will find that even in a decade of single digit returns you can grow your overall after-tax returns to approaching the double digits and that's what you need if you want to be able to spend some, make up for the impact of inflation, and continue to maintain your purchasing power."
Traditional ways
She notes that in the 1990s a traditional 60/40 stock/bond portfolio - with stocks mostly comprised of US companies - would have generated about 13.5 per cent returns on average annually.
"Fast forward to this decade and if you had that traditional portfolio - through the end of 2007 that portfolio instead of getting you 13.5 per cent would have got you 4.5 per cent and most of that return actually came from the bonds not the stocks," she says. And it would be showing big losses this year.
So the question at JPMorgan Private Bank became: "If you're used to double-digit returns, or close to it, how do you as a wealthy family find them in this decade?"
Keating and Janine Racanelli, head of the bank's Advice Lab, looked at how its most successful clients had got returns back towards the double digits.
The explanation, says Keating, is they did "a whole bunch of things" over four broad areas: portfolio construction, leverage, liquidity and estate planning.
The Advice Lab then spent months modelling a hypothetical $100 million family and running "before" and "after" scenarios over the period between January 2001 and December 2007. What it found was that the "before" scenario returned 5.4 per cent a year, while the "after" scenario - where the family had implemented basic wealth planning strategies - generated an additional 5.6 per cent of alpha annually.
This is where it came from. First, a $70 million 60/40 portfolio was modified to include more international stocks and alternatives with absolute returns, such as hedge funds and structured products. Over the seven-year period that was back-tested, the portfolio generated an extra two per cent of alpha.
Second, JPMorgan took a closer look at client's cash as it has found many wealthy families end up holding more in cash than they realise. This is especially important in a low interest rate environment. "Focusing on cash strategically and making sure that you are earning an appropriate yield rather than letting it sit relatively idle can add another one per cent in return, which is significant," Keating says. "If 10 per cent of the portfolio is in cash it's probably another 10 basis points on the aggregate portfolio. You are eking out every little bit of extra return you can get."
Leverage
Next was leverage - in other words, not only looking at the asset side of clients' balance sheets, but also the liabilities.
"Leverage can be an enhancer of returns. For example, a modest amount of leverage - say just 10 per cent of the portfolio, which is potentially tax deductible for US clients, can add another 90 basis points to returns," Keating says.
Finally, estate planning. "If you are a wealthy family you have a partner in your wealth and it is the government, particularly when you want to pass wealth to the next generation," says Keating.
JPMorgan found that by using basic estate planning strategies - such as transferring a portion of the assets into a Grantor Retained Annuity Trust, or GRAT - the $100 million family added 2.6 per cent in additional value to their portfolio.
While generating additional alpha from a back-tested model is one thing - hunting for alpha in the future is another. Keating believes it can be done and that, given current market and economic conditions, now is a good time to implement these strategies.
"You can claw your way back up to those double digit returns, but you have to do it by focusing on every single financial discipline - the portfolio, the cash, the leverage, the estate planning - and if you do all of that you're hopefully back up to 10 per cent or higher returns," she says.
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