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Private Wealth Management - December 12, 2008

ALM does provide us with better risk management - an interview with Joost Rietvelt

Joost Rietvelt

In this month’s interview we speak to Joost Rietvelt of Van Lanschot about the practical implications of using ALM techniques in private wealth management and also welcome an article by Guus Boender and Ronald Janssen on Asset-Liability Management for Private Individuals. Joost Rietvelt runs the private banking activities of Van Lanschot in The Netherlands, Luxembourg, Switzerland and Curacao.

In a recent EDHEC publication produced in partnership with ORTEC Finance, “Reactions to an EDHEC Study on Asset-Liability Management Decisions in Private Wealth Management,” industry practitioners gave their views on the potential advantages and challenges of using ALM techniques in the private wealth management sector. The paper shows that professionals see major advantages to using these techniques. Still, there are some concerns about the successful implementation of this new method. The complexity of ALM and the difficulties of transferring the institutional ALM approach to private wealth management are seen as hurdles.

As proposals to use ALM in private wealth management are recent, the existence of these hurdles comes as no surprise. Additional research into the application of ALM to specific client contexts, as well as the education of private wealth management teams, would in all probability make it possible to clear these hurdles with greater ease.

Could you tell us a little bit about your activities and how asset-liability management techniques are applied in your business?

Joost Rietvelt: We are a Dutch private bank with discretionary asset management and financial advisory services in the Benelux countries, Switzerland and Curaçao. Our advice to our clients is based on an integration of two critical elements that are not always part of the private wealth managers’ approach: the objectives of each client and the risk in reaching such objectives. In this regard our core principles do not differ significantly from those of the institutional ALM: the use of these techniques is facilitated through our change towards client-centric portfolio construction in two ways, i.e. the fundamental change in the approach of our advisors and the implementation of the right models supporting this change. For our client, personal ALM studies are conducted with the ORTEC Finance solution for Private ALM. These studies educate our clients in the risks of investing and help us define client risk profiles.

What in your view is the added value of a Private ALM solution? Would you see several advantages or is there one overriding benefit in particular?

Joost Rietvelt: This solution is essential in our client acceptance procedure, because, as stated above, the client profile is based on it. We strongly believe we can educate our clients in understanding their own financial future, since they usually don’t have the total picture, and the risks of investing. At the start of the investment process the client starts with realistic goals and during the relationship with the client we monitor these goals, so the expectations of the client are managed very well. As an example: if we feel that a given client has a higher willingness to take risk than the ability to do so, we will try to illustrate the impact of the negative outcomes on the basis of the client’s specific objectives rather than any concept such as Value at Risk, which is difficult to understand. In other words, we define the probabilities of clients reaching their objective and the risks associated with it.

What sort of reactions does the idea of using ALM for private wealth management inspire from the end users?

Joost Rietvelt: Once they are educated they are convinced and mostly enthusiastic because of the insights provided. The average human being is not interested in or capable of understanding the finer details of modern risk management, but what definitely captures their attention is the direct link with the objectives they have set for themselves. More simply said: by making an ALM analysis we re-establish the link between the decisions in a client’s personal life and the decisions in the investment portfolio. As an example: many of our clients wish to save for the purposes of investing in a home of their own. Although the tax consequences of such savings can be captured in a deterministic sense relatively easily, the risk associated with the savings process can be overwhelming, unless somehow linked to the expected purchase price. Our client centric process aims at simplifying this process, but not at the cost of relevance to the risk management required.

What are some of the practical issues involved in implementing an ALM solution for private wealth management?

Joost Rietvelt: In implementing the Private ALM solution of ORTEC Finance we learned quite a bit about the diversity of mindsets in our organisation. And although we value this diversity in the interaction with our clients, as far as risk management is concerned, we had to achieve a certain consistency. So the change in management aspects of such an approach should not be underestimated: the change we achieved is very substantial and beneficial for our clients, but did not come about without the focus of the management and the buy-in from the advisors, both are critical to the success!

Do you agree that liabilities are hard to define in private wealth management?

Joost Rietvelt: Not particularly, but you cannot always easily distinguish between real liabilities and client ‘wishes’. In our discussions on the risk management these differences are clarified and the level of risk we can take differs between the so-called liabilities, i.e. objectives that must be met (education/pension) and the more discretionary spending-based targets.

Do you think that the complexity of ALM techniques is a drawback that might prevent broader uptake from the industry?

Joost Rietvelt: This is definitely an issue. However, the advisor is part of the process for a reason: he/she is supposed to be able to make the process understandable to our clients; after all, this is the basis for client-centric advice. Otherwise the internet and product platforms based on it will certainly be cheaper so if the advisor does not offer value added, what is the role she/he has? But we do feel that at this time the fact that we are able to use the ALM techniques effectively gives us an edge over less focused organisations.

Do you agree that ALM ensures better risk management and are you satisfied with the risk management tools at your disposal?

Joost Rietvelt: By definition, yes, ALM does provide us with better client centric risk management. In addition to using ALM, we are currently implementing a ‘dynamic risk model’. Once implemented, we will be satisfied with our risk management tools.

Do you think that academic research in this area is useful and what sort of practical problems would you like to see addressed through research?

Joost Rietvelt: For our education we consider it useful. Issues that need to be addressed are, for example, inclusion of derivatives and/or structured products in a diversified portfolio.

About Joost Rietvelt

Joost Rietvelt has 20 years of experience in the financial industry both in Investment Management and Investment Banking. He worked for ING for 12 years. Prior to joining Van Lanschot Bankiers, he was member of the Management Board of IMC, where he developed a number of new businesses ideas. Today he runs the private banking activities of Van Lanschot in The Netherlands, Luxembourg, Switzerland and Curacao.

About Van Lanschot

Van Lanschot Inc. is the oldest independent bank in the Netherlands, dating back to the eighteenth century (1737). Its rich past forms the cornerstone for its current service as a Private Bank, focusing primarily on private capital and entrepreneurs. Since the early days wealthy individuals have sought the advice of Van Lanschot Bankers in the sound management of their estates.

Van Lanschots’ service is organised along four business sectors: Private Banking, Asset Management, Business Banking and Corporate Finance and Securities. In 2006 they announced the successful acquisition of the Kempen & Co. Bank.

Since the late 1960s Van Lanschot’s main office has been located in ’s-Hertogenbosch. Besides 33 locations throughout the Netherlands, Van Lanschot also has subsidiaries in Belgium, Curaçao, France, Luxemburg and Switzerland.

Van Lanschot and Asset-Liability Management

Immediately after the implementation of new regulations, the Act on Financial Supervision, MiFID and Basel 2, Van Lanschot redefined its objectives, including its most important one: to give the client better insight into the risk and return of the investment portfolio so that the expectations of the client can be managed. ORTEC Finance, an expert in Risk and Return modelling and consultancy, offered the desired solution through Private ALM, which provides detailed and comprehensible insight based on institutional ALM fundamentals developed over more than 20 years.

Asset-Liability Management for Private Individuals

by Guus Boender, Ph.D. and Ronald Janssen, M.S.

The use of asset-liability management (ALM) – a risk policy that covers investments and liabilities together in an integral manner – already provides larger and smaller banks, insurance companies and pension funds with a solid and fitting foundation for their financial strategy. It does something very similar for private individuals through private wealth management, because the ALM methodology makes sure that the risk-return profile of the investments corresponds nicely with the risk-return profile of the investor.

Even if financial markets turn out to be efficient, and all the thousands of investors worldwide and their computer programs manage on a daily basis to erase the last remainders of inefficiency, then we will still be confronted with this basic rule: no risk, no return. But how do you succeed in limiting investment risks to an acceptable minimum, without endangering the ultimate return goals you have set for yourself? A methodology that can be of great assistance in solving this puzzle is Asset-Liability Management (ALM). The first objective of ALM is to help determine the correct risk profile of the client. Subsequently, it becomes possible to identify clearly what the most suitable investment categories are.

Wealth management

Objectives can, even in the case of wealth management, differ substantially from one to another. In the Netherlands the central objective is generally to keep the assets index-linked/inflation-proof/stable in value in the long run, in an effort to account for tax expenditures; while in other cultures it is not unusual at all for wealthy people to make large-scale donations to charitable organizations in their own lifetime and experience the resulting exposure first-hand. But in both extremes limits must be set to short-term risks. After all, if only the expected long-term developments were of importance, then the best portfolio would generally be the highest risk-carrying portfolio. After all, this will be the portfolio that renders the greatest returns in the long run. Yet it will also create the greatest risk exposures, both in the short and the long term.

Emotional risk tolerance

Sometimes an emotional reaction can lead to the liquidation of a high-risk portfolio at the worst conceivable moment. Emotions, therefore, need to be controlled in the investment process. Risk limits for the short term can take various shapes and forms. Short-term risk management often uses a Value-at-Risk measuring stick. This instrument defines how much real capital/equity may be lost within a certain time-period, say a year, at a specific probability. But from an ALM perspective it is more sensible to connect the short-term risk limits to the overall strategic objectives. If the objective is simply to retain the value of the starting capital (to keep it index-linked, inflation-proof), then we can add a restriction to the ALM model stating that the real value of the assets will never drop below a certain risk level, for example 75% of the initial capital.

Stable in value / index-linked assets / inflation-proof assets

After the risk-return profile has been determined, ALM will seek the optimal investment policy in line with the central objective. Several investment aspects are of crucial importance in this regard, one of which we will discuss here. This is keeping the assets index-linked/inflation-proof. Simple correlation calculations teach us that stock returns for example negatively correspond with inflation. Statistically speaking, therefore, shares would prove a bad inflation hedge. But two recent PhD dissertations (Steehouwers, 2006; Hoevenaars, 2008) demonstrate that in the long run shares can actually provide significant protection against inflation. As a consequence shares should be well-represented in the portfolios of investors seeking long-term stability in value. The same applies for investment categories like real estate and infrastructure, which, due to the increased risk of inflation, can count on a growing interest from long-term investors.

About Guus Boender

Guus Boender (Ph.D.) is Non-Executive Director of ORTEC Finance and professor in ALM at the Free University of Amsterdam.

About Ronald Janssen

Ronald Janssen (M.S.) is Managing Director of the Private Wealth Management business of ORTEC Finance and lectures Private ALM at the Erasmus University of Rotterdam.

The Origins of ALM

For several decades now, the Netherlands has been one of the pioneers in asset-liability management (ALM). Pension funds laid the basis for the ALM methodology when they, in order to keep the premium contributions and overall pension schemes affordable, were eager to exchange parts of their entirely fixed-rent portfolios for shares.

At the time, three essential questions needed to be answered:

  1. How much risk is justified, with what kind of ambition in mind?
  2. Given the risk profile, what is the optimal Strategic Asset Allocation (SAA)
  3. If the risk does actually materialise, who among the main stakeholders (e.g., the companies, the current or the future participants) are willing to account for the losses and to what extent?

In dealing with these strategic questions, ALM models can lend support in three different ways:

  1. The use of ALM will discipline policy makers to not immediately grasp for quick solutions, but to work in a transparent risk management process with a clear governance;
  2. ALM allows policy makers insight into the risks of various policy options;
  3. With the sophisticated optimising procedures of the ALM models it becomes possible to determine strategic asset allocations that use the available risk capacity in optimal fashion.

Naturally, other big consumers of ALM are banks and insurance companies. However, particularly banks have clearly not managed this task correctly: the risks connected to their products seemed unknown both to them and their clients. But it has especially been the governance of the risk management and ALM process that at some banks has been proven inadequate. Relatively recent newcomers to ALM are housing associations, corporations, charitable organisations, county (provincial) governments and family offices. This growing popularity probably explains why every Dutch university offers a course in ALM these days.