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Investors exploring the financial markets have had a very difficult time in recent years seeking profits in return for risking their money. And then, there is always one precious asset class in one corner of this world that performs well. But, it feels like you only find out about this vein of wealth, when everyone else has already safely returned from the treasure hunt. At that very moment, you decide to dedicate more time to follow the financial market in order not to miss out again in the future.
FIRST THING'S FIRST
Frustrated about missing out on that opportunity, you call your banker and blame him for not letting you in on that profitable story. He is struggling to come up with a comforting answer because he does not want to lose you as a client but hardly ever will he admit to not knowing anything about this investment. The banker is aware of the agonizing truth that no one knows beforehand which stock, bond, index, their derivatives, structured product or whatever investment will generate a positive return. He compensates by calling you every day to give you his idea of where the next treasure could be found. After all, there are millions of opportunities - you just have to pick the right one!
To live up to your own promise you put yourself through that phase of being flooded with ideas and products and spending a countless number of hours trying to make the right investment decisions. You realize quickly that it is fairly simple to obtain an overall view of the markets but that one final question remains; how do you translate it into an actual investment? You are so frustrated by now because you are not confident enough to make that decision of how much money should be allocated to which asset class and which region. Thus, you tell yourself that making investments is too risky and therefore you keep everything in cash. But then again, there is always one asset class in one remote corner of this world that performs well! Sound familiar?
THE CHASE IS ON
Admittedly, you are somewhat lost in translation. But that is not a reason to terminate your chase for wealth. All you have to do is find a trustworthy and capable crew that takes you safely to these remote corners of this world. They will not only get their hands dirty for you but also translate your investment objectives into reality. Think yourself as of a mezzanine, sponsoring the treasure hunt while enjoying life in a safe environment. By the way, the official naming of these treasure hunters is 'Portfolio Manager' the contract name is 'Discretionary Mandate'.
 REALITY CHECK
A discretionary mandate will certainly release you from the burden of making continuous investment decisions. Delegating the management of your assets to a specialist can compensate for lack of time and financial expertise. However, a managed portfolio will only give you peace of mind, if your specialist adheres to well-defined wealth management guidelines and if the risk characteristics of the investment strategy pursued by your specialist match your risk tolerance. By risk I mean the positive and negative fluctuation in asset value based on the developments of the financial markets. The three distinctive questions in the diagram will determine your risk tolerance. Your banker should be able to present you a selection of predefined investment strategies with their risk and return statistics. If not available you should at least take a close look at their performance. A long track record of 10 and more years will show you the fluctuation of annual returns, as well as an average return since inception of that specific strategy. Rather than concentrating on the maximum returns you should ask yourself if you could handle the negative returns. Choose the strategy with the lowest fluctuation of returns if your investment horizon is short. Otherwise pick the one you feel most comfortable with.
PEACE OF MIND
Let's assume that you define yourself as a conservative investor with a focus on absolute returns and capital preservation. That is because you need all your funds back in four years to fund a housing project and you realize from past investments that you can only sleep well at night if the fluctuation of your assets invested is relatively low. Matching your risk tolerance by blindly allocating a percentage of your funds to bonds and equities, etc. is not a successful strategy. Why? Because studies show that 82%1 of the portfolio performance is determined by the strategy - and not by stock-picking as widely believed! Many investors would raise the question now of why they should hire a specialist to replicate this strategy. Well, because you would still have to pick the appropriate investments to successfully translate the strategy. Furthermore, the trading cost you incur would most likely be as high as what you would pay your specialist all together for managing your portfolio.
The strategy shown in the chart (across) is a conservative portfolio that generates returns mainly from bonds. The past performance of this portfolio shows that the relatively small allocation to equities is large enough to enhance portfolio returns but too small to wipe out bond returns. The allocation to alternative investments is made to achieve positive returns at times when markets trend sideways or downwards. Against popular opinion, alternative investments or in this case hedge funds tend to have a superior risk and return profile compared to traditional investments (higher returns for the same level of risk). Further assuming that your reference currency is US dollar, the majority of investments are in US dollar. A small allocation to foreign currency holdings can add extra performance. The portfolio manager entrusted with your assets has the leeway to deviate from the neutral position shown in the chart in order to achieve returns higher than the underlying benchmark. Based on the neutral position of the investment strategy shown, the average annual return is 7.3% from 1995 to 2004. During that period this strategy would have doubled your assets and never recorded a negative annual return. As good as capital protection!
 REAL CAPITAL PROTECTION
If this strategy looks as adventurous to you as hiring treasure hunters to go dig in your own backyard than I have another solution for you. How about an equity-focused strategy that explores some of these remote corners of this world? Too risky! True, but what would you say if I guarantee to pay back your initial investment? Please let me explain.
CONSTANT PROPORTION PORTFOLIO INSURANCE (CPPI)
CPPI is a dynamic asset allocation strategy that protects investors from large losses by providing a specified minimum payout at maturity but offers upside potential. The big advantage of CPPI compared to an option based strategy is, that there is no upfront payment for capital protection. This is possible because of the multiplier in the algorithm shown in the box, that divides the CPPI protected mandate into a dynamic portfolio and a security portfolio. Again, the calculation of that composition is entirely rules-based. If the value of the dynamic portfolio increases, more and more assets are re-allocated from the security portfolio to the dynamic portfolio and vice versa.
The multiplier reflects the volatility of risky assets chosen in the strategy. A strategy with a highly volatile asset tends to have a lower multiplier. Therefore, a dynamic portfolio invested not only in equities but also in bonds has the advantage of possibly having 100% of the initial assets invested in the dynamic portfolio.
A higher multiplier makes the re-allocation between the two portfolios more sensitive to changes in the cushion (portfolio value minus floor). That means that the CPPI tracks the performance of the same but non-protected dynamic portfolio much closer. Remember, a percentage of the portfolio value might be in the security portfolio.
A higher multiplier results in a higher probability that the portfolio value reaches the floor during a market downturn. In that case, no more re-allocations to the dynamic portfolio can be made. The floor is the lowest value the combined portfolio is allowed to reach. It is calculated by discounting the guaranteed payout at maturity with the current market interest rates. The currently rising interest rate environment lowers the floor and increases the initial allocation to the dynamic portfolio. Regardless of the interest rate level, the floor will increase over time and match the guaranteed payout at maturity.
PUT AN END TO YOUR JOURNEY
There is no doubt that financial markets have become more difficult to predict based on historical data. However, historical information such as past track records give us still an indication of how a strategy might perform in the future. The important point is, that you choose a professional portfolio manager that has enough resources to continuously analyze the markets and react within the boundaries of the agreed investment strategy. All you have to do now is find yourself a proven specialist who helps you hunt down these treasures but not get lost in translation.
1 Feri Trust 2002, Financial Analysts Journal May/June, 1991: Gary Brinson, Brian Singer and Gilbert Beebower, "Determinants of Portfolio Performance II: An Update"
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