Some wealthy investors are exploring investment policy statements, which are used by foundations to create parameters for how securities are bought and sold

November 22, 2013

Individuals Find Ideas in the Institutional Investment World

By PAUL SULLIVAN

MAYBE the Standard & Poor’s 500-stock index crossing 1,800 this week is a sign of a stock market bubble, or maybe the companies that compose it will continue to grow. There are arguments for both, but the correct answer will be clear only at some point in the future. For investors trying to make rational decisions about their portfolio today, this is little comfort. The chatter can be scary. And advice like “stay the course” is about as helpful as telling someone to stop worrying and be happy.Sure, there are plenty of advisers working with their clients on financial plans. But these plans can be too general and easy not to follow. Recently, I started hearing more about advisers who were adapting something from the institutional investment world for individual clients: investment policy statements, which are commonly used by foundations and endowments to create parameters for how securities are bought and sold and guidelines for making changes to holdings and hiring and firing managers.

An I.P.S., as it is known, is to a financial plan what a Range Rover is to a minivan. Both will carry your children safely, but only the Range Rover will power up a gravelly mountain. Of course, most people who own a Range Rover are traveling the same, well-paved suburban streets as the minivan driver, making all that engineering a bit of overkill.

To some, the same argument can be made for an I.P.S. It’s just too much. But the people I spoke with who had one talked about a difference in their investment performance and their state of mind.

Robert McCarthy, a lawyer who held senior positions at MTV, Viacom and Time Warner, said he started working with an adviser who uses an I.P.S. in late 2009. “I was very chastened,” he said. An I.P.S. “was a guide to the level of risk in each portfolio.”

Like many, though, Mr. McCarthy came to this the hard way. He is on his third adviser since big losses in 2000 and 2008. The same thing happened with David A. Gelb, a periodontist with expertise in implant surgery. His portfolio today is the same value as it was in 2000, before it dropped by nearly two-thirds. Now he is a true believer when it comes to an I.P.S.

“I said, ‘My God, why didn’t any of my other advisers ever discuss something like this with me?’ ” Dr. Gelb said. “If you don’t have an objective or a game plan, how predictable can you be?”

In its structure, an I.P.S. is fairly simple. Investors sit down with their advisers and assess their return objectives and comfort with risk. Then the adviser designs the portfolio with that in mind. Where an I.P.S. goes further than a financial plan is that it sets a target allocation for each type of security — say, stocks — and adds an upper and a lower range for the percentage of the portfolio that can be in that security.

In the case of Mr. McCarthy, the I.P.S. for him and his wife sets a target of 40 percent for stocks. That percentage can go as high as 60 percent and as low as 20 percent.

“If I get nervous about the state of the stock market and say, ‘This is too frothy,’ the exposure gets reduced, but it won’t go below the minimum equity number,” he said. “But market performance can have that effect, too. If you go over the maximum number, it gets reduced.”

The idea is to keep people from getting so bullish that they overcommit to a sector and lose when it inevitably falls, or so bearish that they sell their investments and go to cash.

“This is standard operating procedure for an endowment, a foundation or a pension,” said John W. Rafal, the founder and vice chairman of Essex Financial Services, which manages approximately $4 billion for individuals and institutions. “After the crashes of 2000 through 2003 and then the crash of 2007, ’08, and ’09, we thought this would give our clients the same protections we give to pensions.”

Beyond establishing the ranges for a particular type of investment, Mr. Rafal says he asks clients about their investment history, comfort with risk and knowledge of asset classes but also about their family history, education, sophistication, views on giving money to charity and their children and, ultimately, use for their money.

“It’s to keep everyone rational in irrational markets,” he said. “It’s never going to be perfect with an individual, but it’s better than if you have no policy.”

Mr. Rafal, who advises Mr. McCarthy and Dr. Gelb, said the reason for the imperfection was that members of an institution’s investment committee use the I.P.S. as a guide to fulfill their fiduciary duty and to provide continuity as people rotate on and off the committee. With individuals, it’s their money, and they can change their minds.

Dr. Gelb said he credited the set rebalancing of his portfolio with reducing the volatility of his investments and making him more comfortable that the gains he has achieved are less susceptible to being wiped out.

Jordan Waxman, a managing director at HighTower’s HSW Advisors, said he required all of his clients to have an I.P.S. He sees it as a way to lay out goals in a structured way. But he admitted that he could do this because he has only 50 clients who together have $1.25 billion with him.

“The reason it doesn’t work for small clients is not because of the client but because of the adviser,” he said. “Most advisers have hundreds of small clients. They can’t spend the time to write an 18-page I.P.S. for each client. The best they can do is summarize their clients’ goals.”

One way around this may be what Tanglewood Wealth Management did. John Merrill, its founder, said he realized in the mid-1980s that as people began talking about asset allocation as an art or a science that it was just as important to gauge how his clients felt. From that, he came up with six versions of an I.P.S., including conservative, moderate and growth versions.

“The biggest single thing we do is talk to them in terms of their prior investment experience because at some point, they have all jumped ship,” he said.

And when they call to do that now — as happened with a client a few months back during the government closure — Mr. Merrill said he suggested modifying their allocations within the parameters. “It keeps you in there,” he said. “The worst thing you can do is go to all cash. That’s where people fumble.”

Of course, a full-blown investment policy statement for an individual is only as useful as what it contains. “Some are two pages and don’t have enough detail, and some are so long that no one is ever going to read them,” said Pat Boyle, investment strategist at Bessemer Trust. “The best ones are three to five pages, and they’re written in English, not by attorneys.”

He said that for families with multigenerational wealth, an I.P.S. can help transmit values around money, but for most wealthy clients the firm produces investment guidelines, which suffice. These guidelines are focused on traditional investment objectives, like returns, risk tolerance and spending.

Still, other firms take a view that it is better to focus clients on goals, like paying for college or buying a second home, than on the hard numbers. This is what Northern Trust has developed in a robust technology platform that, in real time, allows people to match how their money needs to be invested to pay for what they want.

“The purpose of an I.P.S. is essentially to put some discipline and structure around an invest strategy,” said Scott Koch, senior vice president at Northern Trust Wealth Management. “But one of the questions you first have to ask is why is the strategy what it is in the first place. If you don’t understand the why, it’s hard to adhere to any discipline.”

Even with an I.P.S. most investors are still going to be subject to some degree of emotion in their investing. “I don’t feel handcuffed by this thing, but it’s been a useful tool,” Mr. McCarthy said. “My advisers push back when they feel I’m overreacting to things.”

And that will mean more than someone saying, “Stay the course.”