Wealth Inheritance Planning As Strategic Asset Allocation

Since we established the first family trust in China in September 2012, critics have long complained that many companies are selling family trusts as “Wealth Investment Products” and are misleading clients in this way. I want to stress here today is that selling family trusts purely as “Wealth Investment Products” is certainly not right; however, the absence of proper strategic asset allocation in wealth inheritance planning is very likely to cause the entire wealth inheritance plan to eventually deviate from the established direction, or even completely fail.

Convinced of the great importance of asset management, wealth management and asset management industries have employed lots of financial engineering technology to conduct in-depth research and discussions. However, there is a very small and simple link that is in urgent need of further optimization. In fact, even a tiny deviation from this link may affect the overall planning. This link is “Know Your Customer” (KYC).

Let’s assume that you have a client named Newton who has just experienced a major setback and lost a lot of money in his investment in a South Sea Company. You have probably heard of this story, but it is not our intention to go into detail about its authenticity. Or, let’s assume that the client is highly educated and just as smart as Newton and has just been through one of the craziest financial bubbles in history. The model created by him was much better than any financial engineering model (incomparable to our “smart beta”), and can be used to estimate the movement of celestial bodies. So, how do we persuade our client to trust us with asset planning? I think most salesmen tend to say something like “Surely you are the one of the smartest physicists in the world, but investment is a profession that is best handled by professionals.” Considering that a person as smart as Newton also makes mistakes in timing and has suffered huge losses (as in the case of investment in a South Sea Company), we have a very good chance of persuading our client to hand over his investment affairs to professional fund managers and fund companies.

Then suppose that you happen to be currently working for a fund giant (Fidelity Fund), and that the company has the best fund manager in the world (named Peter Lynch). In this context, you have recommended Magellan Fund, a well-known fund managed by Peter Lynch, to your client Newton.

Magellan Fund is one of the most highly rated funds in the whole world, however, on average, its clients are losing money. This is a problem faced by all of our salesmen when conducting asset allocation for clients. First, you responsibly persuade your clients to hand over their investment affairs to professional wealth management or asset management companies like us, and then you recommend the best fund manager in the whole market or the whole world to them. And then what? Your clients may end up losing money. So, when we say that asset allocation determines returns, what are we really talking about?

To answer this question, let’s review our example above, and see what our sales manager does for Newton. First, he persuades Newton to hand over his investment affairs to professionals; second, he selects the most highly rated fund for him. However, has he paid close attention to the most critical aspect of asset allocation? What is the core issue in asset allocation? Generally, we appraise the performance of a fund manager according to three factors: timing, stock selection, and what else? In the past, we used to build models for timingusing all kinds of methods and advanced technology, and we constantly improved our products. At the beginning, there were many active public funds; later, the lack of an adequate incentive mechanism gave rise to a big private equity fund industry. In contrast, public funds also continue to move forward, and have begun to take the initiative or “smart beta”. However, have they really solved the most critical issue of asset allocation?

There are two core reasons that lead to investment failure, that is, greed and lack of patience. Today, I want to take this viewpoint forward by saying that both greed and lack of patience are probably the result of the absence of adequate efforts on the part of salesmen. In other words, greed and lack of patience should not be simply understood as clients’ psychological tendencies or their habits. In many cases, what seem to be greed and lack of patience are in fact a passive act or a compulsion. For instance, when a client has a child who is almost school-going age, he has to redeem his funds to purchase a house in a school district. In case of an unexpected financial crisis, the owner of a company experiencing financial difficulties needs funds to save his business. In cases like this, simply accusing him of being greedy or inpatient is simply not fair. On the contrary, if you have not taken these circumstances into consideration or have not persuaded the client to take these circumstances into consideration, these will become the weakest link in wealth inheritance planning. As a result, this tiny inconspicuous KYCdetailcan jeopardize the overall effect of strategic asset allocation. KYC and strategic asset allocation can be seen as two sides of the same coin, which are closely related and complementary. The influence of the two factors is inconspicuous in the process of a single product sale, but becomes extremely obvious in family wealth inheritance planning, mainly because of the length of the investment period and because KYC is more detailed. Unfortunately, there are few advisors who can perfectly combine the two factors, and this has significantly influenced the effect of wealth inheritance planning.

As indicated by a review of the standard processes of the whole industry, KYC constitutes the first step; the second step is to determine the risk tolerance of the client; the third step is to decide the optimum asset allocation ratio, or, put simply, to decide the proportion of high-risk funds to be purchased. You can check with various departments of your company to see if they have satisfactorily accomplished all these processes. In order to decide the allocation ratio of equity funds according to the asset allocation model, we must take into account an important parameter within KYC, that is, the risk preference of the client. If you have mistaken or even misunderstood your client’s real risk preference, it will be impossible to realize their wealth inheritancegoals.

From the 1960s until today, the wealth management industry has seen generations of asset allocation models, and used many advanced models for quantification; however, there are mainly three generations that have witnessed extensive applications. As far as the three generations are concerned, a passive risk balance model is frequently introduced. In demonstrations to clients, the risk balance model has the highest net value and the smallest fluctuations, so salesmen tend to recommend this model to clients; it is a natural choice. However, I want to say today that this is completely wrong. After giving such a recommendation to your college roommates, your relatives and friends, or your most loyal clients, it may end up having a negative impact on their families’ financial security.

This is a typical efficiency frontier. The first step is to find an optimum point on it; after that, the risk preference of the client is determined on the right side; the final step is to set the ratio of risky assets to risk-free assets based on benchmark portfolios and risk-free bonds. This is the entire process of asset allocation.

My question today is: What kind of model do you use for determining risk preference? You can consult the sales department of your company to see which model they use. Here we give a few examples to show the problems involved here.

The first example involves a client involved in one of the first batches of pension schemes in China in 1990. At that time, he earned what seemed to be a lot of money back then (roughly 100,000 RMB). He was quite successful then, and he cared about his younger sister a lot. He offered to prepare a pension scheme for her with 10,000 RMB, and told her that she could rest assured and could even quit her job in a state-owned enterprise if she should ever get wrongly blamed. In his opinion, 10,000 should be enough to provide a pension guarantee. In the end, his younger sister did not quit her job, instead she retired in the last two years or so, and the pension provisions continued until now. In China, the proportion of stocks and other equity assets in the insurance funds of an insurance company cannot exceed 30%, so the average rate of return is about 8% to 10%, i.e., an annualized rate of return of 6% (which is pretty high). However, calculated by this rate, the 10,000 RMB in 1990isjust 50,000 RMB today, which means that the promise made by the elder brother cannot be fulfilled today.

Pension planning in 1990

What has gone wrong?

As discussed above, in analyzing the risks faced by a client, usually a benchmark combination is used to configure his asset allocation. The problem is that, when calculating the allocation parameters, data from a one-year window is used. Thus means that when a client wants to buy and hold for 10, 20 or even 30 years, the volatility of stocks may be lower than that of bonds. Thus, in calculating the benchmark combination, it is dangerous to use one-year volatility, even to allocate only 30% of stocks.However, if you use the volatility of a longer period (say ten years), your benchmark portfolio may suggest the allocation of 70% of stocks or more.

The Future for Investors by Jeremy Siegel

Is the discussion over at this point?

Obviously not. Is it possible to solve this problem by adjusting the volatility calculation method according to the terms required by the client?

In another example set in 2004, after 15 years, a client came to you with 10 million RMB. He wanted to give it to his child when he turns 18 years old, either as tuition for college or as start-up capital for a business. His child was six in 2004, so there would be a period of 12 years for investing the 10 million. This was the information from the client. What would your plan be?

I’ll try to illustrate this with two plans:

What the client really wanted is an optimum asset allocation plan for the 12 years. There are two options: decentralized investment in stocks all over the world,or a classic “foolproof” asset allocation portfolio (consisting of 30% stocks, 15% commodities, and 50% long-term government bonds), which is more robust, conservative and thus more suitable, considering that the money was intended to be left to his child. According to historical data, from 2005 to today, the average rates of return of the two portfolios are 12% and 9%, respectively. Which one would you choose? I tend to select the first one, as the client has a very high risk tolerance and his money is open to long-term investment (12 years). Investing in stocks all over the world, especially stocks in emerging markets, means higher returns.

Results: If all goes well for the client in terms of his business and life in general during these 12 years from 2004 to 2017, the first option means an increase from 10 million to 31.91 million, while the second option (the strategy of selecting the world’s biggest hedge fund) means an increase from 10 million to 29.49 million. Simply put, the first option outperforms the second one, and the second one decreases by about 600,000 RMB today. In this sense, if you are patient and not greedy, the return on index funds may exceed that of the world’s biggest hedge fund. This is the long-term investment philosophy that everyone is promoting.

Let’s further assume that the client’s company ran into difficulties in the global financial crisis of 2008, and its cash flow did not make it through 2008. After liquidation, he asked for an allocation of 600,000 RMB for living and starting a new business. However, from that day on, things never got any better, and he would draw 600,000 RMB every year. Calculated at an inflation rate of 3%, he drew a total of 6.1 million RMB in the period from 2008 to 2017. As a result, in the case of asset allocation, the account balance increased from 10 million to 20.3 million; in the case of investing in stocks all over the world, the account balance increased from 10 million to 20.15 million. The investment strategy did not change, but there was a deficit of 150,000 RMB. The main reason was that, in the case of asset allocation, 600,000 RMB was drawnwhen it fell by 7%; in the case of investing in stocks all over the world, 600,000 RMB was drawnwhen it fell by 48% in 2008. An expenditure of 600,000 RMB changed the outcome.

What if a greater amount were drawn?

If the amount drawn was 12%, the gap would have widened to 3 million.

If the amount drawn was 18%, the account which invested in stocks all over the world would be empty by 2015 and, by the time his child went to college in 2017, there would be no money left; in the case of asset allocation, there would be a balance of 5 million in the account.

Or, conversely, if the client was very successful and purchased other companies in 2008,his success in business brought in excess cash flow, so he made an additional investment of 6%. As a result, in the case of investing in stocks all over the world, the account balance increased to 43.66 million; in the case of asset allocation, the account balance increased to 38.68 million. If an additional investment of 18% was made, the difference would be more significant.

Complete victory

To sum up, there is absolutely nothing wrong with the understanding that asset allocation determines returns; however, close attention should be paid to several important aspects.

If your friends or clients think you are an expert in the industry and ask for your opinions about stock selection or pension provisions, please be especially cautious with the KYC link before giving your advice because your advice may have substantial bearing on their families’ future.

First, pay attention to risk measurement, and figure out the intended period of investment.

Second, thoroughly understand his expenditure arrangements. If he requires expenditure from this money, please note that the tortoise can outrun the hare in 99% of cases. This means that asset allocation is recommended if the client has expenditure requirements, as a portfolio with an average rate of return of 9% in the case of asset allocation can outperform a portfolio with an average rate of return of 12%.

Third, if he intends to make additional investments, the money should be entirely used for investing in stocks.

For the sake of your families, friends and clients’ lives, please refine your risk questionnaire, and do a better job in the KYC area, as there is no starting again in life.

In short, asset allocation determines returns but, for different families with different cash inflows and outflows, the optimum strategic asset allocation varies as well. For a salesperson who is in the business of planning family trusts for clients, “wealth inheritance is the source, while asset allocation is the water”.The benchmark portfolio is strategic asset allocation, but it takes time and energy to figure out how to set the benchmark portfolio.

Some people may say that life itself is too unpredictable. What should we do then? I think that, with regard to what’s predictable, we can go with asset allocation; with regard to what’s unpredictable, we can go with optimum asset matching. I’m looking forward to seeking continuous perfection with you.

All of us have families and careers to tend to, and sometimes we may have to draw some money in case of emergency. So when a friend comes to you with great reverence for opinions about which stocks and bonds to purchase, please calm down first, and at least prepare a detailed KYC form and ask him/her about their families, daily necessities and possible future expenditures. Basic and simple KYC questions like these constitute the basis of strategic asset allocation. The cornerstone of wealth inheritance planning is strategic asset allocation.