Finding Yin for a Client's Yang http://wealth.bloomberg.com/wealth/wealth1/articles/invest3_0001.html For investors with the bulk of their wealth in a single stock, completion funds may be the right counterweight to put balance in a portfolio Meet Edward. He's got a problem. As a senior vice president at one of the largest U.S. pharmaceutical companies, he has been accumulating restricted stock and stock options for the past 14 years. And because Edward feels so good about the drug industry, he has even allocated a chunk of his discretionary assets to his company's competitors. Currently 80 percent of Edward's net worth is tied up in his own company's stock and another 10 percent is invested in the stock of his competitors. Recently Edward's CEO instructed all managerial employees to maintain at least 60 percent of their net worth in company stock. This mandate came as good news to Edward's financial adviser, who had been eager to diversify his client's outsize equity position. He figured that Edward would now unload some of his company stock. The trouble is, Edward doesn't want to sell. During the past decade, top managers--and increasingly middle managers as well--at the largest blue-chip companies saw their net worth balloon on the strength of one stock. A combination of stock awards, restricted stock options, pension benefits, and sheer growth of the largest-capitalization domestic stocks has contributed to the dilemma now confronting many investment advisers: When a client can't--or won't--part with an equity behemoth, whether for practical or political reasons, what choices exist to diversify the portfolio prudently? Many investment advisers acknowledge that structuring a portfolio around an outsize equity holding is as much an art as a science. Complicating the task is the emotional stake the client is likely to have in maintaining this holding. Some advisers draw from modern portfolio theory, devise proprietary asset-allocation models, or buy off-the-shelf asset-allocation software in the quest for a remedy; others believe the problem must be tackled individually for each client and don't use a template to guide them. Lately, as the need for solutions has grown, yet another way to address this predicament is gaining attention. From the institutional world of asset management comes the idea of using a completion fund--also known as a completeness fund--to manage the so-called misfit risk, or style-bias risk, that results from a portfolio imbalance. The idea for these funds dates to the late 1980s when pension officials were searching for ways to correct the portfolio imbalances that are a common byproduct of active management. Pension officials realized that the use of multiple managers in a defined-benefit equity portfolio did not guarantee exposure to either the total equity market or an equity benchmark. Instead the manager-selection process exposed portfolios to an added layer of risk because the top-performing managers the pension officials hired very often were choosing stocks from the same hot investment style. Often more than half of a portfolio's nonmarket risk can be attributed to the biases created by managers' investment styles. For years pension officials paid dearly to hire and fire managers based on their performance, only to discover later that much of that performance was attributable to their investment styles. Plan sponsors asked their consultants how to solve the diversification dilemma inherent in retaining outperforming managers who select stocks in whatever style is currently in favor. One answer that emerged was the completion portfolio--a custom-built fund designed to add exposure to styles or sectors not provided by a particular group of active managers. Now the question is, Can this tool be applied to an individual investment portfolio whose primary problem is a sizable equity imbalance rather than a style disparity? "Yes," says David Tierney, president of quantitative consultants Richards & Tierney in Chicago and widely acknowledged to be the father of completion funds. Tierney devised the risk-control concept while working at Amoco Corp.'s pension-investment group before opening his own shop in 1984. His advice to investment advisers: "The concept of a completeness fund is fine to use in this situation. It's there to correct unwanted biases in an investment program." He does caution that in an individual portfolio with taxable status and relatively limited resources (compared with, say, a $60 billion pension fund), an adviser has a different set of constraints in seeking to increase diversification. To remove unwanted bias, individuals can't buy 250 stocks the way an institution can, warns Tierney, so they must find that combination of securities that provides the most diversification while continuing to pursue their overall goals and target returns. As a risk-management tool, the dynamic completeness fund--or DCF, as Tierney calls it--was not created to shoot the lights out in terms of returns; it was designed to offset certain risks inherent in portfolios. And the configuration of any DCF is determined by the risk-return profile of a given pension-plan sponsor. So, too, in the world of wealth management, an adviser may confront the same stick-with-the-winner syndrome, Tierney points out, because it's often emotionally difficult for clients to diversify away from a hot equity, especially if it's their company's stock. "The key to structuring a completeness fund," Tierney concludes, "is in risk budgeting," or determining how much risk a client is willing to bear and how to allocate that risk given the client's return expectations. "It's founded on squeezing unwanted risk out of a program," says Tierney. The objective is to ensure returns are adequate while removing any uncompensated risk--plugging the style holes, in other words, that arise from having all the eggs in one style basket. Arnold Wood, president of Martingale Asset Management in Boston, builds and manages completion portfolios for pension funds. He notes that a wealthy individual's problem of owning too much large-cap equity is the obverse of that of an institution, which is usually underweighted in those stocks. Still, in both cases an adviser must first identify what the client is trying to achieve in terms of a benchmark and build a portfolio that appropriately fills in the gaps relative to the benchmark, removing unwanted style bets. Like Tierney, Mike Bergmann, senior executive vice president of Asset Management Group in Denver, stresses the challenge of advising a client to diversify away from a large equity holding to which he or she is emotionally attached. "This is an interesting and difficult issue for the practitioner," he says. "Everyone intellectually understands diversification. But they have trouble implementing it when something they like is part of the equation; they feel handcuffed." These days even middle managers are coming into Bergmann's shop with 50 percent of their net worth in one stock. He begins the diversification process by drawing each individual an efficient frontier, or portfolio-performance benchmark, based on projections of the world economy's future as it might affect the client. He uses both proprietary models and economic forecasts to analyze 14 asset classes, often arriving at a barbell-shaped portfolio, one end of which consists of the single large stock holding while the other consists of cash, real estate, foreign stocks, and bonds. Despite the logic of owning these diversifiers, the client doesn't always feel comfortable with that solution. "Some clients will find it too aggressive; others, too conservative," observes Bergmann, "or they will want historical data included in the model." Their emotional attachments can be overwhelming, placing additional constraints on the portfolio-optimization process. Bergmann treats the problem as a two-pronged issue. First, he explains to clients that the bulky equity holding should be classified as a separate asset class. On top of that he piles the idea of using a completion fund that provides the best diversification to which the client will agree. This can include the use of foreign stocks, small-cap stocks, and cash but often has an additional large-cap equity allocation. In his quest for a secondary enhancement to the asset-allocation process, Bergmann is exploring the use of an actively managed completion portfolio structured as a separate account. One product under consideration is created by State Street Global Advisors (SSgA) in Boston. The SSgA product, managed by principal Alistair Lowe, uses a BARRA optimizer, or risk model, to build a 50-stock active completion portfolio. Here's how it works: First, the risk model processes information about industry sector, style, yield profile, and market capitalization of the stock in question. After arriving at some common factors, a portfolio is designed within the universe deemed relatively uncorrelated to a client's major holding. Then some expected outperformance is built in by using analysts' forecasts for stocks. This active product is one of three completion-portfolio products offered by SSgA. The second product is a passive portfolio devised by simply removing the stock in question from an S&P 500 index fund. The third, also a passive product, adds another layer to the second strategy by dropping out all stocks in the same industry sector as the client's outsize holding. Robert Clarfeld, president of Clarfeld Financial Advisors in Tarrytown, N.Y., has selected the third product for some of his clients. Clarfeld has developed his own asset-allocation software to deal with highly concentrated portfolios, which in his practice often include equities from the financial-services industry. Clarfeld's software uses a formula for mean-variance optimization based on the covariance of the company or industry to specific asset classes. "The problem is developing meaningful inputs," he says. "Some clients just say, 'Forget about [all these complicated formulas],' " explains Clarfeld. When that happens he works to encourage these folks--who may have up to 80 percent of their net worth in one stock--to reduce risk by buying stock in industries with a low correlation to their own. For example, the energy sector historically has provided ample diversification to a portfolio overweighted with financial-services stock, because the threat of inflation or rising interest rates has had a negative effect on banks but not energy companies. Also, energy companies are built on hard assets, such as oil and heavy equipment, and therefore operate differently than financial-services companies. So Clarfeld might use energy-sector funds, like the Vanguard Energy Fund, to help diversify a portfolio heavy in financial stocks. But, he says, "in general, when you can go with individually managed accounts, do it. They have more-predictable tax attributes than a mutual fund." For this reason, he hired SSgA to use sector and stock analysis to build an S&P 500 index fund that didn't hold any financial-services stocks. A further refinement of this portfolio might carve away a stock like General Electric because of its formidable presence in the financial-services arena; GE Capital Services now accounts for nearly half of the parent company's $100 billion plus of revenues. Clarfeld has also turned to Value Line Asset Management to help clients desiring a more active approach. Philip Orlando, CIO at Value Line, put together a contrafinancial program for Clarfeld's clients by excluding the 25 percent of the S&P 500 composed of financial-services companies, defined as banks and insurance companies, and utilities, which have a high correlation to financial-services companies. Orlando then focused on the remaining 75 percent of the market, overweighting stocks with low correlations to financial services, using the Value Line Timeliness Ranking System to create a growth portfolio. Each portfolio that Orlando runs for Clarfeld's clients is a separate account, and all are nearly identical, with some exceptions for special tax situations. Whether an adviser chooses to structure a completion fund with a separate account or a mutual fund, using active or passive stock selection, the first thing that must be done is to arrive at an asset balance. Dick Vosburg, executive vice president and CIO of Legacy Wealth Management in Memphis, says that he has gotten "more sophisticated in the last five years" in his approach to finding that balance for clients with single-stock portfolios. Vosburg uses Ibbotson asset-allocation software to construct an efficient portfolio. For a client whose net worth is tied up in shares of, say, a real estate investment trust--a number of which are headquartered in Memphis--Vosburg may allocate as much as 50 percent to international equities, with more going into short-term bonds than longer-term bonds and nothing invested in intermediate-term bonds. The portfolio would also have a core of U.S. large- and small-cap equities. If a client agrees that the portfolio makes sense, Vosburg implements the strategy, reminding the client with each quarterly report that the odd duck in the total program is the completion fund designed to complement the outsize holding. Sometimes Vosburg uses mutual funds to set up these portfolios; other times he uses a separate account, the costs of which--around 50 basis points--have lately been very similar to those of mutual funds. For an executive at Federal Express, for instance, Vosburg might suggest a U.S. large-cap portfolio without FedEx, airlines, or trucking companies, and he might overweight several oil stocks because so much of FedEx's cost structure is fuel related. In addition, Internet stocks might be underweighted, because more Internet-driven sales equal more FedEx deliveries. For one particular retired oil-company executive who preferred mutual fund investing to setting up a separate account, Vosburg made use of Morningstar reports that show sector weights as ratios to the S&P 500 index. Assuming that about 9 percent of the index is composed of natural-resource stocks, Vosburg searched for mutual funds with less than 4 percent allocated to that industry. Other criteria, such as expense ratio and custodian, were also screened in selecting a completion-like mutual fund portfolio. Robert Horowitz at New England Investment Management in Stamford, Conn., is another adviser who has focused much of his practice on designing completion funds for clients--many of whom are Wall Street investment bankers. Salaries and bonuses for that group can be high, but so is the risk of being let go. For that reason, Horowitz recommends short-term bonds as the best diversification vehicle because of their stability. After that he tries to find uncorrelated assets, which is always a tricky undertaking. For example, emerging markets have the lowest correlation to large-cap U.S. stocks, but selecting them for a portfolio doesn't necessarily guarantee that a client's company and the uncorrelated asset class won't go down simultaneously. Besides, these negatively correlated stocks may be highly risky themselves, adding more instability, rather than less, to the portfolio. When a client has 70 percent of his net worth in company stock, determining how the remaining 30 percent should be invested depends a lot on the client's risk profile and risk tolerance, says Horowitz, echoing the opinions of his peers. "You want to create a whole separate diversified portfolio," he explains. "People have a tough time diversifying into things that are not going up as fast as their company's stock. They also don't want to invest in a stock that is going down." Consequently, he might recommend investing 20 percent in short-term bonds and 10 percent in emerging markets and international small-cap stocks, which he believes are an overlooked asset class. Simply diversifying with any international stocks isn't enough when so many foreign companies operate along the same lines as American companies, he says. "You need asset classes or regions that are isolated," says Horowitz, and "small companies are less global [than larger ones]." Still, he adds, "I would be happy pushing for a full 30 percent in bonds." Yet one more element that might be included in the completion-fund equation is an accounting of what Tom Connelly, president of Keats Connelly in Phoenix, describes as a "back-of-the-envelope estimation of the present value of future earnings." He offers the following as an example of this approach. Let's say an oil-company executive has $500,000 of company stock in his retirement plan, $800,000 in a 401(k) plan restricted to company stock and short-term fixed income, and $2 million in other taxable investments and IRAs. "Instead of looking only at the $2 million, we look at asset allocation based on the entire estate," he says. "We back out the things we can't control, like company stock, retirement-plan assets, and real estate." Then he looks at the discretionary assets that remain. In some cases, Connelly recommends including 5 to 15 percent of inflation-sensitive investments, based on a 5 to 10 percent chance of a repeat of the economic conditions present at the end of the Carter presidency, when inflation--as measured by the Consumer Price Index--ballooned to 13.3 percent in 1979 and oil was around $181 a barrel. For an oil-company executive, however, such investments would be deleted from the completion fund because presumably the executive's net worth would skyrocket along with the price of oil, and the following might be added: more foreign stocks than domestic; fixed-income investments; and/or domestic value stocks. The portfolio will look bizarre when taken out of context, says Connelly, but that situation exists in the pension-fund world as well. Bizarre-looking or not, the completion-fund concept is catching on with advisers as more clients come to them with outsize equity holdings. The notion of wringing out as much unintended risk as possible from a large-cap style imbalance while still catering to the client's preferences is shaping the way assets are allocated at a growing number of financial-planning shops. The trick is finding the right balance for your client. By Frances Denmark, January/February 2000 Frances Denmark, a financial writer who covers U.S. and international finance, writes regularly for Plan Sponsor magazine. Her articles have also appeared in Treasury and Risk Management, Dow Jones Asset Management, and other financial publications.