Bridge over ocean
28 March 2018 Multimedia

Asset Allocation for Private Clients: Goal-Based Asset Allocation and Practical Portfolio Implementation

  1. Michelle Watson, CFA
Michelle Watson, CFA, discusses the science versus the art of portfolio implementation and how to account for behavioral issues of both the client and the adviser; how private investments figure into the asset allocation mix and what clients need to understand about them; and the challenges and opportunities of client reporting—including understanding what you can and cannot control. 

MICHELLE WATSON: So I'm excited today to be here in LA to talk about goal-based investing and portfolio implementation. I really feel that-- I think, anyway-- that investing and the way people behave around money is really interesting. And so basically, this is a talk for me. Maybe it will work for you. But I really like talking about that.

In this discussion, we're going to talk about four things. First of all, we're going to talk about behavioral mistakes. So I want people to start thinking about the behavioral mistakes that your clients make, that your prospects make, that even you make.

And I think that, again, we all make mistakes. And it's all around how we are as humans. And I think that understanding your mind is really important.

Then we're going to talk about the goal-based investing framework and the behavioral accounting framework that goes along with this. Because really, what goal-based investing is really getting the client to stop making the behavioral mistakes that they do in the long run.

And then we're going to talk about portfolio implementation. That's the geeky side of things. It's actually taking what you've learned from the client and actually implementing it from a numbers standpoint and really thinking about all the things that we use in portfolios to build portfolios for clients.

And then last, I think I want to talk about the reporting challenges that we have around it. So we can talk about all those things. And I know I've seen tons and tons of slide decks talking about goals and talking about all of that.

But at the end of the day, you put a portfolio together. And then you go back, and you report to them. And you're really talking to them in investment language and not in the language that really focuses on goals. And I'm hoping that there's technology people here in the room and other people that have found solutions for reporting to clients.

So a little bit of transparency about me is that I think good things happened in the crisis. I actually had started at a new firm in 2007. And the first thing I ended up talking about was cash, which I thought, wow. I should have known that something terrible was going to happen in 2008.

But good things came from that. And I think one thing that I would say is that, on average, I think the investment community has become more humble and actually really thinks more succinctly about risk, about liquidity. Because even the big endowments actually got into trouble in an illiquidity squeeze and had to do things that they weren't expecting to do in portfolios. So I think those are good things that happened by being surprised at what happened in 2008.

I also think-- I don't know if it happened at the same time. But I think that the advances in technology came at that time because we needed to create more efficiency around what we were doing as a group.

And then lo and behold, the technology industry came and said, wow. We haven't really looked at the financial services sector for a while. We can do some things. And algorithms can actually help and build client portfolios. And we can interface with clients in a better way.

So instead of being scared about robo, I actually really like it. I actually think it's very interesting. I think it's actually going to help us communicate with our clients. And I think we should embrace it as a community. So it helps us do our job better. It helps us communicate with clients faster. I think all those things are good things.

Stepping back a little bit, I thought it would be interesting to go through the evolution of portfolio management. And I love her slides that had the people looking and all grouping together and looking at their computers and then looking at their devices. Should have had that open up along this diagram.

But I think if you look at client portfolios, you can actually tell how long they've been investing. I don't know about you. Show of hands-- how many people have low-cost basis stock that has been there forever?

And you look and you say, oh, my gosh. This client has been investing for years and years because those are the eight stocks that they bought back in the day or their grandfather bought back in the day. And we're still taking pieces of that off because it's low-basis stock.

And then we moved on to the 26-stock portfolio that now is fully diversified. And maybe we have some meaty bonds in it.

And then you get to strategic asset allocation where people are totally using the tools that are available to them. They're using private investments. They're using international investments. I can't tell you how many times I've seen portfolios that only have US investments-- and even today, surprisingly.

And then now, I think what has happened is that people really recognize that clients, people, humans-- we're just not rational. And so goal-based investing helps us into using both sides of our mind. And so now we're going to be working on that goal-based investing.

I don't think it's much different than strategic asset allocation, to be honest. But I think it gets to more succinct portfolio construction. It gets at better questions for clients.

So let's just go back to what are the key elements of goal-based investing. I think risk-- now you talk to risk. And I think she was talking about nobody cares about standard deviation, especially on the upside. They only really care about on the downside.

And so clients-- when you're talking to them about risk, you should be talking to them about risk of not meeting a goal and then really then talking strategically about that goal prioritization. That will help you actually create a better portfolio for clients. Because if they need cash now, that's going to be different. But if they don't need any cash now, they're bringing in a lot of cash. And they're actually able to think about retirement.

You also have to look at the amount of assets that client has. It's so great to talk about legacy and all that ultra-high net worth. There's nothing better than a $100 million client.

But when you're talking to $2 million clients, that's all their assets. You're not going to get to legacy. We're not going to get to philanthropic things. We're going to be working on making sure that they have a good life through retirement.

I think that, again, focusing on cash flow actually gets you to be more succinct in how you're going to get to those goals and really making it so that clients actually don't sell things too soon-- that actually, they like that cash flow. And again, that might not be the most efficient portfolio. But from a behavioral standpoint, you're actually getting them to do better things.

And then putting it in a mental accounting framework-- and so this is-- actually, you'll look at a couple of slides later. You'll see that this is one of the mistakes that we have is that clients don't look at the portfolio on an overall basis.

They're looking at little pieces of it, and it causes them to make mistakes. But if we put things in buckets, it will help them make better decisions. And so we want to help focus them on the long-term goal.

Has anybody read this book? Show of hands. Excellent. It was so funny. I read this book, but I went to Audible. And I downloaded the review of this just to give myself a little refresher on it.

And I have to tell you, they did not like the book. It was like, this guy was so arrogant. And he changed things up in the middle of the book, which he did. I'll be honest. But I think sometimes profs are that way. And so you have to work through it.

I think this quote actually says everything. "We think much less than we think we think. So we shouldn't ask people to over-think." So I said, of course. I mean, I can't even say that.

But really, what this is about-- and I think it's important to think about it-- is that we have two sides of our brain. There's system one they called it and system two. And system one is your faster thinking processes. And it's really talking about what you do from instinct.

And then system two is our more analytical brain. And I'll be honest. What was interesting in this book is that system one is in control of system two. So if you have a really strong system one brain and you think intuitively, you might not even get to system two. And I'm sure you have clients that think that way-- that you just can't get them to think analytically about anything.

So I think that-- this is what I thought about when I started looking at that and saying, you know, it's just hard to make decisions. And because our mind, our animal brain, actually wants to make a quick decision, we think about fear. We think about happiness. We think about other things that are quick decisions. And so really getting to force ourselves into that analytical mind frame is really what we're talking about.

So I thought we'd take some time and just think about our clients. I know lots of you have been in this business for a long time, some of you maybe shorter time. But it's kind of fun to think about some of the things you've seen clients do.

I think in my career, since I've worked with advisors a lot, I think the first one is something I see a lot. I'm smarter than the average investor. I'm very good. I don't have to think about what I'm doing. I'm going to go into that client meeting, already know what they want. I think that happens a lot.

And then you also have your doctors. You have your private equity guys that know one part of the market. They're right in that bucket as well.

I think that also-- I see this all the time-- is the gambler's fallacy. Know when to hold them and know when to fold them. Honestly, how many clients-- show of hands-- had their clients get out of the market in 2008 or a prospect.

And you see them-- look, I have my cash. I got out in 2008, still haven't invested it. They're still sitting there with that pile of cash. And they're still just afraid to really get into the markets again.

I think mental accounting-- as I said, mental accounting is something that we can work with. And so we can use this mistake area and actually mold it to help us get clients to do the right thing. Chasing the hot dot-- people don't like to lock in losses. We all know that.

My favorite is availability bias. I mean, how many of you have clients that have lots of their own company's stock? They maybe leave the company. They're still afraid to sell it. They know that company. They know it's going to continue to be good. They have a really hard time letting go of that, and so getting around that is sometimes very hard.

Selective memory-- that's another good one that I just love. How many times have you been a client meeting? And I love it. You have the husband. You have the wife.

I know in particular, I, was sitting there with a husband. He's telling me about all the great investments he's made. I made two times my money on this. I made five times my money on this. I made 30% on this. I'm just a great investor.

And then you go to the wife. And she goes, honey, don't you remember that one that we lost all our money on? And isn't that other one that we did over there? So selective memory is one of those things.

And I think we all have to kind of get over it. I know we do it. I think it's just to keep ourselves alive. We forget about the things we've done in the past and go, no, no. We're good. We're good.

This, I think, is really interesting. Nowadays, I think in the last few months, we've seen clients actually go through this on a daily basis-- market's up, market's down. By the end, they've gone through the entire emotional roller coaster. And again, your system one brain actually really focuses on this. And you need to be more analytical and push yourself to system two all the time.

So I'm sure many of you have seen this particular graphic. And it's the pyramid. And I've seen it in many presentations. And I've also seen advisors flip right by it.

They look at it-- look. This is how we think about things-- and they flip right by it. But actually, you can use this to really talk to clients and really get into the questions that you need to get in to actually build a better portfolio.

So what kind of income do they have? What do they need for shelter and food? How much do they spend every year? Because sometimes, the $30 million client-- you see those assets-- excellent. But they actually spend that money. It's surprising how people can do that, but they can.

Lifestyle-- what are they doing with their lifestyle? What do they want to do with their lifestyle? Sometimes, you'll have clients. I had a client or a prospect I was talking to the other day. And he was like, I'm really scared of the market.

But when we started talking, he has no debt. He has two houses that he doesn't have to do anything-- he literally has nothing he needs to worry about. He has some income coming in. He doesn't really need to worry about things as much as he thinks. So he can actually take on more risk than was thinking about.

He's like, oh. I actually feel good about the economy. I feel good about things. And so he was talking about a very conservative portfolio at the beginning of the day. And at the end, he was being more rational about his thought process just by talking about, what are your goals? What do you need?

I'm not leaving anything to my kids. I want to spend all my money. Wow. You have a lot of opportunity to do different things.

When we talk about insight, when I talk about insight, I'm talking about you just spend a lot of time on this pyramid with the client. And this could be an hour. This could be two. This could be two and a half.

This could be multiple meetings really talking to the client about what they need, doing an estate dress rehearsal. I heard her talking about all the things that you need to do from an estate perspective. Again, those goals and things are very important.

We move onto this. So we take all that. We know who we have. We know what they need. And now, we can work on the things that we know about how we can meet those goals.

And so going through and actually putting together all the tools that we have-- and this is not just-- I talk about public and private investments. Obviously, you can when your clients have the appropriate amount of money to do that. Using all the tools is what we want to do, but not just in the asset classes that we're talking about.

I think you need to use asset location. I think you need to use the account structures in a really good way. There's more you can do with estate planning than you can ever do on the investment side. And so thinking about wealth from that standpoint, really thinking about fees, really thinking about what you can control-- cost, fees, asset location-- all of those things first.

And then think about the behavior. How does that client think about money? What am I going to do? Am I going to have more cash-flowing assets so he's not selling things as soon? Are we thinking about that we need more growth because they have a better perspective on their assets?

I thought this slide was kind of interesting. I found this on the internet. And I think that this kind of helps you to think about what else is being brought into the program. And I think that we sometimes forget that we have the assets. We're doing this one part of their financial process.

But what are they bringing to the table as well? And so I think it's a really good way-- when we start talking about bringing that financial plan into the investment program-- is, what is their responsibility in this investment plan? Because what did they tell you?

Did they tell you that they were going to work till they were 60? Did they tell you about their college kids' needs? Did they tell you about that philanthropic thing that they're going to do?

Maybe they're going to buy a piece of land. Maybe they're going to do-- actually, these are all just things I'm taking out of the questions that I get from clients and the things that I discover when talking to a client a little bit deeper and really getting to understand what is it that we really need to do with this portfolio.

And then really calling that out when you're talking to your client-- again, what are we going to do? Have you brought in that money? Oh, you left your job? Oh, wow. That's great. So what does that do to the plan-- really going through that with them and really understanding what they're bringing to the table as well so that you're making adjustments along the way.

I think that sometimes, all of us-- again, system one mind. We think we're on track, we're on target. But really, this is an ongoing process that we always want to work with our clients.

And I think that, luckily, technology is making it very easy for clients to communicate with us through text, through financial planning software that gives us an opportunity to say, hey. What has changed? It's right on your device. You can do it any time you want. So I think that this helps us in doing a better job for our clients.

They ask me to talk about incorporating private investments. And I know there's one person in this room that knows this is one of my things that I talk about asset-- is asset class schema. I think that we've done a terrible service to our clients by creating this cool thing called alternative investments.

There's nothing alternative about an investment. There are only so many things we can invest in. There's cash. There's debt. There's equity. There's real and hard assets. And then there's a combination of them.

And so when we talk to clients about putting private investments in their portfolio, we want to put them in the category that they belong in. Because you give people unrealistic expectations when you kind of bucket them into this little alternatives group area because those things do different things. And so when you're trying to benchmark what you're going to be giving to the client for yourself, you really need to know what that is and really help the client understand where that goes.

My personal opinion is that there's only a couple-- if you have clients that are not ultra-high net worth, that they're only focused on the bottom rungs of that pyramid, you shouldn't be adding a lot of private investments because that liquidity is going to become a problem at some point. We don't know. Timing the market is tough. And we just don't know when that's going to be.

I do think that private real estate is a very important asset that you can include in those bottom rungs as long as you do it at the appropriate size. It does add diversification. It can add income to a portfolio.

And I think it's really difficult on the trading and the multi-strategy-type assets out there. And I'm sure there's somebody that's actually doing this today, and they're going to tell me how to work that. And I'm available after this commentary and throughout this conference. And you can convince me that I can use these in a better way.

But they're hard because this is really alpha drivers, I would say, for the most part. And so everybody-- you have to be consistent with that alpha in order to be able to put it in a portfolio and make it work for you.

And so my conclusion has been that if I can do it in the other asset classes, I'm going to take my asset allocation. And I'm going to work it that way. And then the private investments-- that's what I can do for legacy, for philanthropic things, for people that have enough money that can actually take on that illiquidity.

So some of the reasons you might want to put private equity in your portfolios is this particular slide. When you look at this, can you believe it that today, there's half as many stocks in the Wilshire 5000 as there were in 1998. So companies are staying private longer. And buybacks and mergers have made it so that you just have fewer companies to look at. And so I think it's important to bring private investments into your basket of options for clients.

I think that also, just as we talked about the aging of the globe, I think that there are tons of small companies out there that there is a change of hands happening. And so you need to really think about getting involved in those.

And another thing I would say is that with FD, with Full Disclosure, and public equities, where can you add value? I think in the private investment community, you have the ability to make a difference. And so spending time on the due diligence process on private investments I think can add value and add return to a portfolio.

This is just looking at private investments-- the landscape of things available to clients. Again, I would circle private real estate because I do think that private real estate is a core part of an overall portfolio. And we use it to diversify substantially with our clients.

There are different ways to access it. And I think it's really interesting. Today, you see a lot of co-investments, I think, because again, fee pressure is making it so that people are wanting to offer co-investments. People think that's attractive because it lowers the fees overall.

But I would say be careful. Because when a co-investment is being offered to you, make sure you're one of their good clients. And they want to offer that to you because it may be excess they can't get rid of. And so the diligence is really important on those.

Fund of funds-- I think people have strayed away from this fund of funds a lot because of the fee structure. And I know fund to funds are getting that fee pressure pushed onto them. And I think overall, if fund of funds think about that, they could be useful again. But I don't see a lot of them being used today.

I think when you're talking to clients about private investments, it's helpful to put it into a business cycle framework because most of our clients actually have been a part of a business. So this helps them to understand. What should I expect from this investment if I'm in venture?

We know when we start a company, we don't have a lot of capital. And actually, we may need to gather more capital. They shouldn't expect to get money from that right away.

And then going on through the lifecycle, there are different things. There are different opportunity sets that come from that-- so a good way to explain things to clients when you're putting private investments in a portfolio.

So last but not least-- besides the discussion, which I'm hoping will have lots of questions-- reporting. I think reporting has been a challenge and continues to be a challenge. When you're trying to focus on goals, typically, again, what I see is that we've really focused on relative returns.

And so you do all this really great work with the client. You meet with them. You do the financial plan. You're working on all this. And then when you get to the quarterly report, look at what I've done relative to the markets.

That is really not what the client really cares about. It should be what we care about, so I'm not taking anybody off the hook for that. I think that's our responsibility, and we should be looking at that all the time. But I do think that clients really want to know am I meeting my goals and expectations.

I can't tell you how many times I've gone into a client meeting, and they're like, all I want to know is the top number and the bottom number. And is it bigger at the bottom? That's all they really want to know.

And then they want to talk about their family. And then they want to talk about their kids going to college. And then they want to talk about their trip they're going to take. And they want to talk about their business they might be selling.

Those are the really meaty great things that you talk about with clients. So we really need to figure out how to incorporate those things in the quarterly meetings so that that is the focus of the meeting and not really on the relative performance.

I think it's also really hard to incorporate risk. And so because it's easy to focus on return, we always have that number there. But we have a hard time focusing on risk.

Because quite honestly, to get a risk statistic in a portfolio, you need to have the client for a long time because it really doesn't mean anything if you've only had the client for six months. And so trying to get that aspect in there is very tough. And so, again, any technology people that are out there-- I would love to hear any kind of ideas for that.

And after-tax reporting-- we talk about this all the time-- is that we keep talking about the end of the day, all we care about is what you get to take home. After tax, after fees, what is that number? And are we meeting those goals? And I don't know. It's elusive trying to get after tax reporting.

We work with a group called Aperio in Marin County. They're great. And they can do it on that one part of the portfolio. But wouldn't it be awesome if you could do it on the overall portfolio really what was the after-tax return? I think that would be super helpful.

So my company works with a group called Tamarac. Tamarac was nice enough to actually help me with some of their snapshots of what they're doing to try to solve for this problem. This is a snapshot of a report that they're doing with MoneyGuidePro.

So they're bringing at least the goal aspect into the reporting process. So these things are starting to merge and starting to do a better job of actually helping the client focus on what they need to. You can kind of see income in the middle. You can see the value of the portfolio on the side.

And actually, I think that income is really low for that amount of money, but that's a whole other topic. But anyway, this is, I think, starting to get there. We're starting to get to the reporting the way we need it to be.

This one was a snapshot. And as you can see, here we go. There is the phone. So you can actually pick it up on your phone and say, am I meeting my goals? Where is my account? How much income? How much in gains do I have?

And they're trying to be very good about customizing this. So I'm very excited to work with these guys because they're really trying to focus in the right areas of getting this part of the conversation right.

The last slide that I have from Tamarac is really on-- I love this-- on track. Isn't that all we really want? We just want to check the box off and say, yes, I'm on track for my goals. And then I want to be able to talk to you.

So my client wants to maybe give me a message. They can do it right here. They can send me a message right away. And so, again, the robo advisors out there-- and so I will tell you I've used a robo advisor. And I think they're awesome.

And what they do is they send me little feeds of, here, you just earned a dividend. And, oh, my gosh, you just hit this goal. And it is a wonderful thing to have those things.

We can do that too as advisors. We can do it even better than a robo. We can really customize that to the client. So I really think that having those things, having that at the click of a button for your client is fantastic.

So my goal, I guess, today was to hopefully-- maybe one thing in this commentary made you think about one thing you could do a little bit better for one of your clients. That's really all my goal was-- and to have a little bit of fun today talking about a topic I really like.

I would say conclusions are is that goal-based investing I think can create more succinct portfolios. It makes you think more. I know that maybe you think only your clients and only prospects make mental mistakes. I think we as advisors do, too.

We've been in it-- especially if you've been in a long time. You've been in million meetings. You go to the meeting. I know exactly what I'm going to do for this client. And you forget to listen. And so I think if you really focus on what the client is telling you, you can actually be better at creating a portfolio.

And I think that using a mental accounting framework actually gets clients to not misbehave. Show of hands-- how many clients have called more than they have in the last 10 years over the last two months? You got to have clients that are doing it. It's fascinating.

So trying to get them to be comfortable with what you've put together for them so that that call is more about, hey, how are you doing? This thing is happening to me. I see we're on target.

This doesn't get away from having a good, solid investment process. So anything that you can do systematic, anything that you can think of from an algorithm standpoint, anything that you can do to make your life easier doing the right things for the clients I think you should take advantage of.

There are trading systems. There are tools out there. Anything that you can do for asset location, do it. I think it's really important to think about all the tools that we have available to us.

And private investments-- keep it simple. Really keep it simple. Let them know what they're doing with their private investment. Do the due diligence on that. I think they add a ton of value to client portfolios.

And then honestly, reporting challenges are there. But I think that you're starting to see that change. And I'm looking forward to the next five years and where that's going.

So I'm going to open it up to questions, if that's OK for you. I didn't want to take up the whole time because I like the back and forth much better than I do listening to my voice.

SPEAKER 1: Before I jump in, I'm going to jump in with my own question. I hope you don't mind. You mentioned something called the estate dress rehearsal. What is that?

MICHELLE WATSON: Estate dress rehearsal-- we talk about this all the time with our clients. And this is-- again, we were talking about the hard questions you have to ask clients. So what happens when you age? What happens to your estate? What do you want to have happen when you pass away?

And so really going through that process of what counts in your life, what happens if your wife dies before you, what happens if you die before your wife-- what is that going to look like? How much estate taxes do you think you're going to need to pay? Do you have the right estate structures put in place for the future?

And a lot of times, you're going to find that that dress rehearsal doesn't go well the first time. And having two people in the room, husband and wife talking about that dress rehearsal, is sometimes eye-opening. And so having that conversation helps you get to who you need to talk to from an estate and trust planning standpoint.

You have to talk to your accountant. It really gets those things in order. So it makes you have to go through-- makes you have a way of going through the conversation. So we call it an estate rehearsal. It's a rehearsal that we do with the client. Helps them get on track, and it makes it not so difficult to talk about with the client.

SPEAKER 1: That's neat. You mentioned the importance of due diligence, especially when it comes to co-investments today. What factors do you use when selecting private investments?

MICHELLE WATSON: That's a good question. So number one, first you have to have access. So we do a lot of work on working with the people that we know and focus on what it is that they've done historically.

With co-investments, I think it's really important to know who the players are, who they're actually showing the co-investment to, how much they're putting in their overall portfolio, what do they already have exposure to, and why me? Why am I getting this look?

Because sometimes, they just have too much that they're trying to raise-- and so really having the people in place that can actually dig into that individual company, who the players are, what the financials are, and then really then making a solid decision on making an investment.

Sizing is difficult. I think that a lot of times what will end up happening is you'll end up oversizing a position. And so I think that's another thing you need to pay attention to. That might already be in a portfolio that you have with that particular manager. And then if you're adding more to that, you need to think about do you really want that exposure for your client.

Having good relationships with private investors or managers out there is fantastic. And so you can a lot of times get some great exposure to specific companies. But make sure that you have the right type of people on your team that can actually dig into those investments. Just because they're coming to you and saying, hey, I've got this co-investment-- just to make sure you know what it is that they're showing you.

SPEAKER 1: How might ESG investing be tied to goals-based investing? And are you seeing more interest in ESG?

MICHELLE WATSON: That's a really great question. I think ESG is definitely here to stay. And I guess I don't see that it's any different with millennials than it is with the older generation. I think that the older generation is very empowered on impact investing and continues to make strides there and actually puts money where their mouth is.

And so I think what has happened is that that community or impact investing has grown. And so you have a lot more opportunities. And you have a greater investment set.

So as you're talking to the client, this is all about that pyramid and what is important to you. Once you get past their lifestyle, what are the other things that they want in their life? And can they do it through an investment structure? And a lot of times, there are opportunities to do that.

Some people will even do that in their tax-efficient investing. I know that we work with a company that actually is able to really dial in the tracking error and still being able to really focus on getting some of the things out of the portfolio that they didn't really want to invest in. And we always give that as an option for a client and then work around the impact.

Impact investing today doesn't mean you have to give up return. I think there's a lot of opportunity out there. And I think it's just going to grow even further.

SPEAKER 1: That's. Really exciting. How do you handle billing on private assets given the challenges and conflicts associated with valuation?

MICHELLE WATSON: That's a good question. Right now, that's a good question. We've actually done a private investment this year that was unusual in that we invested in a private company directly. We didn't go through a private equity firm.

In that case, we actually did two things with our clients. We do bill. We don't take performance fees on a normal basis. So we typically bill on assets. We're building an overall portfolio for the client, and we bill on assets.

I do think that there is a lot to be said about billing based on what you're doing for the client and on complexity. I do think that's where the world is going, and we do need to think about that. I would say that our company hasn't gotten to that point. We are still billing on assets. And we bill on the overall valuation in client portfolios.

We only bill on what's been invested in private investments. If they made a commitment, we don't bill on the full commitment because we already have the other assets on the other side of the table. So we're only billing on what's been invested with the private investor and on their valuation. So if there's a J curve, you're going to have to wait.

Going back to the private investment that I was talking about, we actually did give some people the opportunity to just be billed on the overall-- what we make on the carry. So we took a carry on that and didn't charge anything on the investment. But that was typically with clients that were not full clients of ours but were just potential prospects that may have thought this was a great investment-- something unusual we've never done before.

I have my pros and cons. I don't know how I feel about it today. But in some ways, it makes sense. If we make a bogey and it's above that, then we'll take a percentage above that. And so the client should be happy with that. And we're not charging them any fees along the way.

SPEAKER 1: This is a very interesting and very new topic. But I've been hearing it at conferences. How should we advise clients on crypto blockchain allocations in the context of the overall portfolio, and particularly from a goals-based perspective?

MICHELLE WATSON: That's so funny. I have to tell you the story. I just thought this was-- talking about a big family and the differences in thought processes.

There were three generations of people in this meeting, so it was the family meeting. And there was a lot of discussion on-- we talked about the regular asset allocation, where we're at, all the different things that were going on with the family.

And then the youngest generation says, I think we should think about investments totally differently. I think that we should equally invest in everything that we do. And if I had put 10% of my assets in Bitcoin, then I'd be super, super wealthy. And I'm like, wow. That came out of left field to me. Wow, OK. So that's where we're at right now.

I don't know how to answer that question. I'll be honest. I think that blockchain is a really interesting thing. And I don't think it's going to go away. I think that there is an opportunity for us to be able to transfer assets and transfer money and things to families all across the world in a very nice way.

I think it needs to be regulated. And so regulation is going to come in on it, and it already is starting to do that. And once it's regulated, I think it will be similar to gold. So sorry for all you gold bugs out there. I think that gold is kind of one of those things as well.

If you have a little bit of it in your portfolio, fantastic. You can talk about it with people at cocktail parties. I don't know how to value it. And it's there. That's fantastic, and it works.

You've seen it move up with a little bit of the volatility in the markets today. People like having that as a hard asset. I think if they regulate this right, I think it will be similar to that. I think it will be another way to transfer wealth. I don't know what to do with it right now, though, so I don't think I can answer that question properly. So maybe somebody else can.

SPEAKER 1: I just opened up Coinbase while you were talking and hadn't looked in a while. Bitcoin is at about this $7,900 today.

MICHELLE WATSON: It was at $7,500 yesterday. Wasn't it something like that? It's really interesting.

There is a bank-- just a commentary-- there is a bank here in California that's actually not taking on the risk of the cryptocurrencies but is actually helping traditional businesses actually work with cryptocurrencies I think that's really interesting. And that's kind of the first steps in actually getting to a place where you can actually have some regulation around it.

And I'm not a big go, go regulation. But I also don't know how you live your life with Bitcoin being at $20,000 and then at $7,500. People can't live their life that way. And so it's not going to take over the US dollar any time soon until they regulate it. And so with regulatory environment around that, I think then it will be something that it would be worth talking about.

SPEAKER 1: You're in California. This is a specific question to California, but it could be other states. Many clients have large wealth tied up in their residence. How does that impact your thinking about allocations to private real estate?

MICHELLE WATSON: That's good. Good question. We think about real estate in general-- I don't think about your residence as being part of the investment portfolio. That's where you live. It may become an asset if you sell it and downsize and those things. But I typically don't include a private or your residential asset in your overall asset allocation.

Real estate-- when we think about it, we think about it broadly. So we think about it globally. We think about it in all the different structures we talked about as core, core plus, opportunistic. We're thinking about it in all different ways. And then geographically, we're thinking about it as well.

I personally think that right now, real estate is kind of in a tough position right now, in particular if it has a lot of leverage on it. So when I'm thinking about a client that has residential real estate, I'm looking at when they bought it, how much debt they have on it, and are they in a safe place. Because I honestly think we're kind of in that space again where you want to be a little careful with real estate.

We're thinking today that we should be thinking about core real estate, income-producing real estate that's strong, that doesn't have a lot of leverage on it. And we're thinking about that in other parts of the market, not just in California. California real estate has worked. And we had some great opportunities over the last 10 years to buy some great real estate. But we're thinking about that outside of just the state for sure.

SPEAKER 1: This is a question about fees in private investments, particularly hedge funds. So is there any reason to include hedge funds in a portfolio after taking consideration for the fees, the illiquidity, and correlation in extreme markets? I assume that means correlation with traditional markets.

MICHELLE WATSON: So somebody must have picked up on my thought process there. I actually don't think there's a lot of reason to put hedge funds in a portfolio because I think you can do it with asset allocation. The only time that you want to use-- again, I can go through the reasons why.

Number one, the consistency of returns have not been there. Number two, like in extreme markets, they haven't acted the way you've expected them to. And then 2 and 20 is just a difficult fee structure to actually get better returns out of.

Don't get me wrong. There are some out there. But again, where are you looking at them adding value? There are active managers, particularly in health care, in technology, in areas that have shown consistency. But I'm typically putting them as an allocation from equity. And I'm taking that risk that there is alpha in that that will help my clients.

Now, when you think about the other things, when I talked about trading strategies, that's like CTAs and tactical strategies that you can use really more to dampen volatility in the portfolio. And again, you have to really look at has that been consistent. Is the expectations there that I'm going to get consistent performance going forward?

I would say from a behavioral standpoint, I can't-- you guys can raise your hand. How many of your clients, where you were saying, I'm going to dampen volatility with the CTA and the portfolio, and they sold it three years later because the markets have gone up. And they haven't done anything for their portfolio. They kept focusing on that one piece, even though those things, those hedging activities actually are helpful in markets that you're seeing today.

I think that, again, making sure you have the right asset allocation-- you can do that with asset allocation. You don't need a 2 and 20 structure to actually get at that. But you have to then maybe create a more conservative portfolio.

Or, like I said, I've used these before. I actually like them. And if you have sophisticated clients that really understand that and can hold onto them and look at it from that aspect, you can do that.

But again, 2 and 20 is a tough thing to get around. I know I've just talked recently to a couple of managers that are trying to break that trend-- 60 basis points. I know that WisdomTree has a long/short that is systematic in approach that is very low cost that does that type of volatility dampening. So unless you can really truly do the diligence, know that you're going to get that consistent performance out of that manager, and get that alpha, I wouldn't put them in the portfolio.

SPEAKER 1: Getting back to the process of goals-based investing, what are the top questions that you ask new clients at a first meeting?

MICHELLE WATSON: Good question. I think when you start talking to clients, obviously, you're going to ask all the main questions about income. What are they bringing in? What are your aspirations? I think really getting an idea of their family-- how do I go through this in a more systematic way?

Again, we start with the portfolio-- what they have, what kind of experiences they've had in the past. Why are they coming to me now? If they have assets right now, what is the reason for being in this meeting today? You can get out a lot of information just by talking to them just like that.

Why are we here today? What has happened that this meeting has occurred? And then you'll get some idea. Maybe somebody passed away. Maybe they sold a business. Maybe they don't like their advisor. They don't like their current advisor and they've had a bad experience.

All of those things-- just the simple, open-ended questions that you need to get at. Who is in your family today? And who are you taking care of? How long do you plan on working?

What do you do for vacation? Typically then, I go off on a tangent. And we talk about travel because I love traveling. So maybe that's not a good question to ask all the time because it makes the meetings run longer.

Really trying to get at the ESG question-- does it matter to you where we invest money? Do you have any hot topics? Is there anything that you're not showing me here in this portfolio that's really important to you?

Oh, yeah. I have real estate in Bermuda or whatever they have out there. It's amazing what people don't even think about. Oh, yeah. I have a piece of property in Colorado. Or my daughter just had me invest in her startup company. It's open-ended questions just to get at all the different things that can help you build that portfolio.

I think really focusing on cash flow and what that means to them and how nervous they get about not having cash in the bank helps you develop a plan for them to make sure that you're keeping them invested. We always think about portfolios from a total return standpoint.

But sometimes, a more effective portfolio is having extra cash flow in a portfolio just because of the way somebody behaves. So talking about past experience with investing I think is really a good way to get at some of those behavioral aspects of things.

SPEAKER 1: This is a question I have as well. Can you talk more about discussing performance as it relates to the clients' goals? Is it verse a certain benchmark? And does that mean we're now going to ignore the other traditional type of returns?

MICHELLE WATSON: That's a good question. No. I don't think that you ignore the other types of returns. I actually think, though, that that's an internal discussion that should be very well versed in because that's what you're benchmarking you to. So could I be more efficient with this portfolio? If you're underperforming from a relative standpoint, maybe you're not putting that portfolio together in a way that makes sense.

So I don't think you get away from the traditional benchmarks at all. I just don't know if they're as effective with clients. So what I think about when I think about goals is really, where are we? So I think about what cash flow did you get and what cash flow did you use. Those are benchmarks that you want to use with clients.

Are we still on target for your retirement? And what happened in the latest time that would take us away from that? And what is that time frame? And that's the tougher part about monitoring a portfolio-- is that when you start with a client, things can happen at the beginning that maybe are less exciting for the clients, maybe a quick decline.

But if you're talking about long-term investments, you shouldn't be as concerned about that. You should actually be excited, especially if clients are actually putting in more money as time goes on. You're like, we're in the beginning of this. And now we have this huge opportunity to add more to growth assets right now-- so really trying to get at what is the term of that money, and are we on target, and really focusing on those things and on goals.

I don't really think that-- again, maybe I'm different. But most of the clients that we work with don't really talk to me about relative performance. They kind of want to know where that performance number is. They want to talk about is it down, is it up.

But they're not really concerned about did I beat a benchmark of any type. Again, I think that's something that you yourself and your team needs to be very well aware of to not disillusion yourself on what you're doing for the portfolio and help you to get to a more effective portfolio.

SPEAKER 1: Switching back to more of a specific question on private investments, have you invested clients via the new alternative investment providers operating under the JOBS Act, i.e. Fundrise for real estate or SeedInvest for venture capital?

MICHELLE WATSON: I have not. So right now, we're looking at-- on the real estate side-- a fund that is actually for low-income housing. So that would be something that is a little bit different for us in that sense. Typically, banks are using that to invest to make sure they are able to loan to people that are in that low-income area.

So that's something new. But I haven't actually done any seed investing, not myself, and not with client money. I think it's a little bit more difficult. It's actually easy. I just think that going into that, I don't think we're up to speed enough in that space, at least my group in general.

SPEAKER 1: What are your thoughts on selling bonds to pay off mortgage debt, especially since many clients may not be able to deduct a majority of their interest moving forward?

MICHELLE WATSON: Oh, wow. That's a good question. I don't like debt in general. And if it makes your client feel more comfortable, I say absolutely do it if you can appease them and make sure that they feel comfortable going forward.

If you're not getting an advantage to having that debt outstanding, especially if that debt may have a reset, you may want to think about doing that. Again, I think that's a comfort level. Obviously, if you can invest those assets in other areas of the market, then that's fantastic. But, as you said, if it's a bond and you can offset some debt, I would do it.

SPEAKER 1: Do work with clients, couples, or families that have difficulty agreeing on the goals?

MICHELLE WATSON: Oh yeah. As I just mentioned, it's an interesting problem and actually kind of fun to work with. I think that sometimes, you'll have families, especially if you're going three generations-- and, as you know, if you get to the third generation, you've already won. Because most the time, you have legacy money that was earned here.

It gets to the second generation. It's typically gone in the third. And I will tell you, after dealing with the number of families in this way, I know why it is that way. They lose touch with how that money was created.

I think that the success I've had with working on that-- it's really putting out, believe it or not, getting them in a room and then getting questionnaires and then actually, in some ways, actually helping the older generation actually let go of some of the responsibility and handing that responsibility to the younger generation so that you can bifurcate that. Because I do think it is important to educate that younger generation and have them have responsibility for those assets.

So you can, again, with goal-based investing, actually get to their goals. But you have to convince the older generation it's the right thing to do. And so, again, it's the art of the meeting in trying to get them to understand how that's working.

And so really getting them to focus on-- this is their money going forward. You have this pile of money. You're good. Let's make sure you're solid and that everything that you want to do in your lifetime we're taking care of. But you can't run their life anymore, so help them into releasing that to give them some more responsibility on that.

SPEAKER 1: This is probably a mental accounting question. Do you think it makes sense to utilize different accounts for different goals considering liquidity, timing, and risk?

MICHELLE WATSON: I do. And I know that's difficult to do sometimes. Sometimes, it's costly at the custodian. Sometimes, it makes it more difficult to trade. There's a lot of reasons why you want that one account that you can work with or those two accounts that you can work with to actually work the portfolio.

But sometimes, for the client and for them to behave appropriately, it makes sense to have those buckets. And so you can actually then-- again, when you're talking about reporting, you can report, here, look. You have your money. You have your cash flow. Everything is good.

Look, we have grown this asset. And it's picking up on your retirement and your lifestyle needs. You have no problem. Sometimes, it's easier for them to adjust to that.

And you can actually then-- if you're doing something even more growthy-- you can get them to forget about that because they've already recognized that that's illiquid, that it's a longer time horizon. They're not putting it in the overall bucket. Report on all of it together.

But really, then you can get them to really focus on, oh, yeah. I'm good here. My life is fine. And, oh, yeah. That still is going. And, oh, that's amazing what they're doing with that venture capital health care.

Look what they're doing in cancer and drug things. And look at the technology that's coming out of this one firm. They're more focused on that as opposed to what is the return and has it gone down or up. They already know that they're good here. And so I think that sometimes, having different portfolios helps a lot.

SPEAKER 1: Wow. I wish we had another hour to ask you questions. These are some great questions from everybody. But thank you so much, Michelle, for this conversation. It's been a pleasure.

MICHELLE WATSON: Thank you. Thank you for having me.

SPEAKER 2: Copyright 2018, CFA Institute. All rights reserved. This program is designed to give accurate and authoritative information in regards to the subject matter covered. It is distributed with the understanding that CFA Institute is not engaged in rendering legal, accounting, tax, investment, or other expert advice. If legal advice or other expert assistance is required, the services of a competent professional should be sought. 

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