Charlotte Thorne, partner at private investment office Capital Generation Partners, explains how volatility is both an opportunity and a risk for UHNW investors – and that a holistic approach to spending and investment can achieve better results.
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Spending is an under-researched area of wealth management, and is often treated as a separate consideration from the investment strategy. In fact, our recent poll of trustees and advisors indicated that nearly half of private client trusts and foundations (40%) do not actively review their spending policy, and that just under a third (29%) do not adjust their pay-out policy in line with the wider economy.
While common practice, we believe this approach ultimately undermines the long term health of the portfolio. The primary reason for this is volatility.
Portfolios must take risk in order to achieve returns. Volatility can offer an excellent opportunities for investors to increase investment returns. However, negative volatility which coincides with a large pay out from the portfolio can have serious implications. It may be easily absorbed in portfolios with very long time horizons, but those which have regular spending requirements, or a shorter time horizon, can fail if volatility and spending are not managed in tandem.
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By GlobalDataA common mistake is to try to manage this problem by changing the investment strategy alone. But this can even worsen the problem. Pushing up a returns target in order to try to meet spending requirements will increase volatility and heighten the probability that the portfolio runs out of cash.
Instead, by incorporating spending into portfolio management strategies, investors can ensure that the spending can continue as planned, while the portfolio’s resilience and ability to sustain market shocks is improved.
Small amounts of flexibility in the spending policy allows the volatility resulting from risk to be absorbed relatively harmlessly. This does not necessarily require spending to be reduced – or mean that beneficiaries have to manage huge fluctuations in their spending power.
We also recommend applying an integrated approach which combines two different spending policies – smoothing to manage volatility in expenditure, and a contingent spending policy to manage the impact of volatility on portfolio growth.
A hybrid of these two approaches facilitates planned spending by creating a more dependable pay-out profile. At the same time, by enhancing the portfolio’s resilience and ability to cope with market shocks, there is little risk of the fund running out of money. We believe this will result in more robust portfolios that better meet the needs of the owners and the beneficiaries.
To assist wealth owners and their advisers with their approach to spending policies, we have prepared five basic rules:
1. Develop an investment strategy in tandem with a spending strategy.
2. To preserve capital set the spending rate at least 1% less than the target real investment return.
3. Map out your spending profile to work out how flexible or otherwise your spending is. Then use simulations to help choose the unique spending and investment policies to meet your unique goals.
4. Use smoothing to provide consistency in spending levels and maximise the future total portfolio value rather than lowering the target investment return. Use contingent spending to increase total portfolio value over time if you have spending flexibility.
5. Hybrid policies combining smoothing and contingent spending policies may be useful if you need some spending certainty.
