The below are the expressed views of Mercer
Mercer’s Financial Intermediary practice is dedicated to advancing the investment management capabilities of financial advisory firms. Mercer leverages its global infrastructure, fortified by providing advice to large institutional clients for nearly five decades, to offer innovative strategies for firms serving individual investors. Our expertise in delegated solutions, manager research, alternative investments and portfolio construction gives us the flexibility to customize our approach.
Entering a new year is a great time to reassess investment priorities to ensure firms are positioned for a brighter financial future. As wealth management firms prepare to lead their advisors and clients into a new decade, we believe the following five areas are critical considerations for long-term success:
1. A view into diversification: active and passive management
Entering 2019, expectations of slower growth, higher market valuations and compressed credit spreads pointed to a muted forecast for market returns and for active strategies to likely outperform passive. However, not only did 2019 experience strong market gains, but performance also continued to favor passive strategies in many asset classes. In market environments where active management is out of favor, it becomes increasingly tempting for advisors and their clients to abandon active management in pursuit of higher returns. History has shown portfolio diversification using both active and passive strategies is key in building durable portfolios. We recommend intermediaries continue to work with their clients to:
- Understand how passive strategies can be used to access certain market exposures
- Evaluate which asset classes are more conducive to active management
- Understand that active and passive can be complementary in diversifying risk
- Consider the expected market environment and why active strategies might mitigate portfolio risk
2. Searching for brighter returns
Amid historically low absolute interest rates across the globe, intermediaries face challenges in generating returns for their clients. At the same time, access to strategies that were only available to institutional investors has continued to expand into the retail segment. Wealth management firms have responded with great interest to this broadened investment spectrum. However, given these often complex opportunities, advisors need to be extra vigilant as fiduciaries in their due diligence process:
- Understand the intended role of the investment in client portfolios and how it will behave on its own as well as contribute to the portfolio in different market environments
- Evaluate the management team’s experience in sourcing investments and executing their strategy through realization (for private markets opportunities)
- Examine the fund’s structure, term, liquidity and fees
- Evaluate operational risk of the manager’s organization — taking a deep look at its employees, money movement, cybersecurity and other key areas of risk
3. Have private markets obstacles gone away?
As private and public markets mature, new trends are emerging that may impact future investment approaches. Investors have been flooding private markets to capitalize on increasing pre-IPO and direct-financing opportunities. The number of listed companies in the US has declined significantly over the years as regulatory and compliance burdens — coupled with the deep sources of capital in the private markets — have allowed companies to stay private longer.1 This has led to more capital for a smaller pool of companies in public markets. Private markets have become more viable for individual investors as the range of retail-accessible vehicles (such as multi-manager portfolios, secondaries and liquid alternatives) increases.
With opportunity comes risk:
- Education is important for both clients and advisors
- Build diversified alternatives portfolios to reduce risk through exposure to different investment strategies and managers
- Seek to participate in different market environments
4. Looking to model portfolios
With advancements in investment technology, wealth management firms are finding it beneficial to use third-party model portfolios — outsourcing portfolio construction and investment selection. Many asset management firms have taken advantage of this trend and are building model portfolios using proprietary funds and ETFs. These offerings present inherent conflicts of interest. As fiduciaries, advisors need to ensure selected model providers have proper governance in place — although firms can outsource responsibilities, they are still liable for prudently selecting and monitoring outside providers.
Things to consider when evaluating a model portfolio provider:
- The segregation of asset allocation, manager/investment selection and portfolio construction duties by the third-party provider
- The resources and tools available and used by the model provider — ensure they are robust
- The level of diversification across asset classes and factors — and how active and passive management products are used
- The incorporation of environmental, social and governance (ESG) factors — understanding a firm’s definition of ESG and what it considers to be a fully sustainable portfolio
- The processes for investment and operational due diligence
- Conflicts of interests — look for proprietary products within model portfolios as well as the provider’s policies around fee-sharing and platform placement fees
5. Viewing tax impacts through the correct lens
Tax efficiency becomes a more critical investment consideration when there is a lower expected return environment. Better technology and tax overlay providers allow advisors to better optimize the tax efficiency of their clients’ portfolios. Further, account aggregation tools provide access to the client’s total asset base (that is, real estate, employer retirement plans, IRAs and taxable accounts) so that advisors can balance taxable and nontaxable accounts to achieve their desired asset allocation changes with minimal tax impact.
Key areas of focus:
- Investing in “tax aware” and “tax-optimized” strategies
- Understanding return sources and associated tax treatment — dividends, interest income, long- versus short-term gains, unrelated business taxable income (UBTI), partnership interests (private investments)
- Reviewing appropriate investment vehicles — the vehicle can materially change the after-tax outcome to the investor based on the way dividends, income and capital gains flow through to the investor; while ETFs have historically been known for their tax efficiency relative to mutual funds, SMAs and/or single manager model delivery portfolios can offer even more tax benefits
- Considering a unified managed account platform and tax overlay manager
- Comparing estimated after-tax returns of available investment opportunities by building out models or finding tax software that can assist with the analysis
- Focusing on “asset allocation” between taxable and tax-deferred accounts — for investments such as alternatives, this can have a material impact on portfolio returns and should be considered before approving or rejecting based on taxable status
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