While the private banking industry is in general relatively well equipped on the tax planning side, with tools that can allow private bankers to analyse the situation of high net worth individuals operating offshore or in multiple tax jurisdictions, the software packages used on the financial simulation side often suffer from significant limitations and cannot satisfy the needs of a sophisticated clientele.

In fact, most financial software packages used by private bankers to generate asset allocation recommendations rely on single-period mean-variance asset portfolio optimisation, a tactic that, for at least two reasons, cannot lead to proper strategic allocation. For one, optimisation parameters (expected returns, volatilities, and correlations) are defined as constant across time, a practice which is contradicted by empirical observation and which involves a substantial efficiency loss, especially when long-horizons are considered. For another, liability constraints and risk factors affecting them, such as inflation risk on targeted spending or real estate price levels, are neither modelled nor explicitly taken into account in the portfolio construction process.

Overall, dealing with a private client usually involves a detailed analysis of the client's objectives, constraints, and risk-aversion parameters, sometimes on the basis of rather sophisticated approaches. Yet it is striking that once this information has been collected, and sometimes formalised, very little is done to tailor a portfolio to profiles, expressed in terms of volatility or drawdown; in some instances a distinction in how the capital will eventually be accessed (annuities or lump-sum payment) is made, but the client's specific objectives, constraints, and associated risk factors are simply not taken into account in the design of the optimal allocation.

It is not the performance of a particular fund nor that of a given asset class that will be the determining factor in the ability of private wealth management to meet investors’ expectations. What will prove to be decisive is the private wealth manager’s ability to design an allocation solution that is a function of the kinds of particular risks to which the investor is exposed, as opposed to the market as a whole.

As in institutional management, the success or failure of the satisfaction of a private client’s long-term objectives is fundamentally dependent on an an asset-liability management (ALM) exercise that aims to determine the proper strategic inter-classes allocation as a function of the client’s specific objectives and constraints. Asset management should only come next as a response to the implementation constraints of the ALM decisions: it is meant to deliver/enhance the risk and return parameters supporting the ALM analysis for each asset class.

Taking an ALM approach leads to defining risk and return relative to a liability portfolio, a critical improvement on asset-only asset allocation models that fail to account for the presence of investment/consumption/bequest goals and objectives. As a result, taking an ALM approach leads to a focus on the liability-hedging properties of various asset classes, a focus that would, by definition, be absent from an asset-only perspective. EDHEC-Risk Institute research (Amenc, Martellini, Milhau, Ziemann, 2009), published with the support of Ortec Finance as part of the "Private ALM" research chair at EDHEC-Risk Institute, has shown that a private investor’s monies need to be allocated to two portfolios, a customised “safe” portfolio hedging long-term liabilities (“liability-hedging portfolio (LHP)”) and a “risky” “performance-seeking portfolio (PSP)”, with the optimal mix between the two depending upon the Sharpe ratio and the volatility of the PSP portfolio, as well as the investor’s risk-aversion and time-horizon.

Key ingredients in long-term investment decisions are the presence of time-varying mean-reverting equity risk premium and time-varying volatility, which induce changes in the strategic asset allocation over time. For example, mean-reversion causes long-horizon returns on stocks to be less volatile than their short-horizon counterparts; in a life-cycle-type of approach, this allows for a priori higher equity allocations in the early life stages. Asset allocation could also be made state-dependent, with the relative level of risk premia-such as the equity premium-being one form of state-dependency to be exploited.

While satisfying their clients’ long-term objectives should be the overarching objective of private wealth managers, the latter are well too aware that respecting a client’s short-term constraints and expectations is paramount to maintaining long-term relationships. The good news is that new forms of dynamic asset allocation strategies allow long-term objectives and short-term constraints to be combined. Risk budgets are used as ingredients in the design of the optimal portfolio strategy and allocation is revised dynamically according to variations in risk budgets, which can be expressed as distances to performance floors and goals. This is not only about risk reduction; it is also about return enhancement through a smarter spending of the investor’s risk budgets. Indeed, strategies that do not include dynamic risk-control inevitably lead to under-spending of an investor’s risk budget in normal market conditions, and to over-spending in extreme market conditions.

Our three-pronged approach involving liability-driven investment, life-cycle investment, and risk-controlled investment, has great potential implications for the wealth management industry. Indeed, it is often said that proximity to investors is the main raison d’être of private wealth managers and a key source of competitive advantages. Building on this proximity, private bankers should be ideally placed to better account for their clients' specific constraints and objectives when engineering an investment solution for them. The framework we have briefly presented here allows the private wealth management profession to do something it has long claimed it was doing, i.e. to offer high-net worth clients customised investment programmes and asset allocation advice that truly meet their needs.