Investment planning for high net worth investors has evolved a lot over the last few years. While earlier we saw investment being advised by the family accountant, the planning was largely opportunistic and reactive. It rarely took into account the macro economic environment and was largely concentrated in a few asset class options. This practice has undergone a sea change with the emergence of two factors – availability of asset class options and the emergence of a structured wealth management system.
Planning for substantial wealth requires an understanding of the asset allocation practice. Asset Allocation is the process of deciding how to distribute wealth among various asset classes and sectors. Although often regarded as a minor investment decision, asset allocation is the cornerstone on which the entire investment process is built.
About 90% of return variability over time can be explained by asset allocation decisions. About 40% of the differences in returns can be explained by differences in asset allocation. Asset allocation is thus, the major factor that drives portfolio risk and return. Asset classes have fluctuating returns and correlations over different time horizons. No one asset class tends to outperform others consistently, therefore it is critical to diversify and adapt your portfolio to the dynamic investment climate. For example if the bond funds did very well compared to the others in 2000 and 2001, then we saw the mid caps doing well till 2005 and the Sensex faring well in 2006 and 2007.
Investment planning is a process of selecting the assets that will generate the maximum return given a desired level of risk. Diversification is a risk management technique, much like hedging, that uses a combination of different asset classes to construct a portfolio. The simple philosophy being that a single asset’s fluctuation would have a lesser impact on the broad portfolio thereby reducing single point risk.
A smart investor, would need to use all the possible tools available to him in different proportions to his advantage. The shortlist of options available today can broadly be classified as Equity, Fixed income, Alternates, Commodities and Structured Products.
The relatively better understood ones like equity and fixed income can be further manipulated to exhibit different characteristics as required. The investment manager can vary and achieve different risk profiles by using styles, themes, tenures, mandates and capitalization while constructing the portfolio.
Investing in commodities could one element to improve your portfolio construct. Commodities can provide an interesting asset allocation option helping you hedge against inflation and benefit from surging global demand. Investors must understand the cycles that commodities typically go through and must have an educated view on the macroeconomics affecting it. Because commodities prices usually rise with inflation, they tend to offer protection from it. Unlike other asset classes, commodities could benefit specially from an unexpected inflation surge.
Using structured products is a must in piecing together your portfolio. They help formulate risk profiles that traditional asset classes cannot. A structured product is generally a pre-packaged investment strategy which is based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuances and foreign currencies. A feature of some structured products is a "principal protection" function which offers protection of principal if held to maturity.
Also mixing alternates like private equity or real estate through funds or directly help an investor provide a potentially longer term kicker in his portfolio. Pre leased properties add an element of stable returns while the underlying asset has a potential to appreciate in value. Due diligence in identifying the right properties and ensuring that the deal is correctly structured assumes a lot of importance.
At the end remember no one has a crystal ball to gaze into. An HNI must demand the best options for his portfolio while understanding the dynamics of the underlying asset and must insist on an asset allocation that works for his risk profile. Like any housewife will tell you, it takes all ingredients to make a perfect recipe.
Disclaimer: The views expressed in the articles are personal of the authors and do not reflect the views of Kotak Mahindra Bank Ltd.