Change is Here

In a recent survey of 335 high net worth investors conducted by my firm, Paladin Advisor Research, 37 percent indicated they were beginning to adopt investment principles used by universities and pension funds. That’s a far higher number than the survey has shown in the past and it’s a significant trend: It means they’ll hire fewer financial advisors, pay lower expenses and reduce their overall risk. What are these institutional investment principles and how can they help you?

Beat the Market

In the past, these high net worth investors selected advisors who claimed they could outperform the market—that was how they justified their higher fees. But in reality, most active managers lag the performance of the markets, in particular after fees are deducted and over several years. Beating the market requires managers to consistently predict the future performance of individual equities, and though advisors sometimes get on a hot streak, they can’t beat the market over longer time periods. Returns revert to the mean.

Excess Diversification

The individual with more than $10 million to invest uses, on average, eight advisory firms. These advisors may be specialists in one asset class or generalists targeting multiple classes. The investors’ goal: Minimize risk by spreading their investments across eight disciplines that invest in multiple asset classes and management styles.

But this investment practice has a consequence most investors don’t realize. Each manager, whether a specialist or generalist, executes an investment strategy that results in an average portfolio of 50 securities. Even allowing for some inevitable overlap in holdings, these investors end up with hundreds of positions.

Over the past couple of decades, institutional investors figured out that their combined holdings essentially amounted to a closet index fund, producing performance similar to a broad-based index like the Russell 3000. They were getting market returns but paying excessive active management fees. Index funds charge management fees of 10 to 20 basis points—about 50 to 80 percent lower than active managers. Plus, passive portfolios have lower turnover, which reduces transaction expenses and capital gains taxes.

Match the Market

Once institutions figured out that beating the market generally meant the opposite, they began devoting more assets to a “match the market” strategy, investing in index funds that captured market performance. Match the market strategies evolved into what’s known as core portfolio management, in which institutions put 50 to 70 percent of their assets in passively managed index funds. The purpose of core investment strategy was to achieve market performance with reduced risk and expense. Institutions that followed the core strategy invested the remainder of their assets with active managers who tried to beat the performance of less efficient market segments. These securities are in markets that are followed by relatively few analysts, creating the possibility of undervalued stocks. For example, these managers may focus on very small capitalization stocks, emerging markets and the stocks of companies in other countries (such as China) that may not exhibit the pricing efficiencies of large U.S. companies.

What the Trend Means

A growing number of high net worth investors following institutional principles may suggest that these investors have become more cautious in the wake of the financial crisis. It’s hard to say if that’s a permanent change.

The shift unquestionably adds to the pressure on wealth management pricing. With more investors skeptical about active managers beating the market, those managers will either have to lower fees and add services or take more risk in their quest for higher performance that justifies the fees they charge.

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