Investors Take a Cue from Institutions

After the devastating stock market declines of the past 3 years, many physician-investors are working with advisors to rebalance their portfolios. Perhaps now is a good time to review how universities invest their endowment and why individuals should model their portfolios along these lines. Most institutional investment committees follow a code of fiduciary conduct. These steps are equally applicable to individual investors.

Asset Allocation

Most investment advisors use questionnaires to evaluate the risk tolerance of their clients and determine the asset allocation of their portfolio. The problem with traditional risk evaluation questionnaires is that they assume a portfolio will earn the same return year after year and that interest and inflation rates will remain constant.

Consider the following example: You plan to withdraw $150,000 per year for your retirement income needs, have a $2-million portfolio, and assume you will earn an average of 7% per year. At this rate, your portfolio will grow to $2,289,800 two years from now. But what if, in the first year, your portfolio earns -10%, and in the second year it earns 24% (not unlikely given the recent market volatility)? In this case, your average return is still 7% over the two years, but your portfolio value will grow to only $2,232,000 two years from now.

Because you need to somehow account for future rates of return, inflation, and interest rates, but can't settle for estimated averages, "Monte Carlo" simulation has emerged as a valuable tool for helping to determine an appropriate asset allocation.

Monte Carlo simulation is a complex mathematical technique that estimates the probability of meeting specific goals in the future. By varying the input factors over your life expectancy, many trials allow you to know the statistical probability that your allocation will enable you to achieve your goals. In our example, a $150,000 annual withdrawal might only have a 65% probability of success when 1000 iterations of randomly generated interest rates are tested.

Diversification

Answer:

How did balanced portfolios manage to have positive returns between 2000 and 2002, given the devastating market in those years? diversification. The only asset classes that had positive returns in these years were fixed income, small cap value, and hedge funds. Exposure to these asset classes was suffi- cient to generate positive returns.

In 2002, universities with an excess of $1 billion in their endowments allocated an average of 32% of their portfolios to alternative investments, such as hedge funds and private equity. When investing in these vehicles, investors should consider a vehicle for diversified exposure to multiple hedge fund strategies within one investment. With generally low correlations to traditional investments, hedge funds can complement an investment strategy and improve performance.

Professional Money Managers

Note:

Many physician-investors who don't have the time to do the necessary research are increasingly becoming aware of the advantages of hiring private money managers over simply investing in mutual funds. In a mutual fund, you own shares of a fund that distributes its share of capital gains to all shareholders. Losses can't be distributed. The worst scenario occurred in 2000, when investors had depreciated portfolios but still had to pay taxes.

This result can be eliminated by hiring a private money manager, whereby you own securities directly, you don't receive capital gains distributions when other investors using your manager make withdrawals, and, most importantly, you can book losses for tax purposes. By researching all eligible managers in the country, your advisor can put together a pool of managers who have excellent track records in their respective asset classes.

Common mistakes:

Be sure to monitor the activities of money managers. placing too much emphasis on recent performance, having unrealistic performance expectations, and hiring managers without taking peer analysis into consideration. Institutional quality reporting available to the individual investor should include performance of the overall portfolio, of each asset class, of each manager within each class, and of a manager in comparison to most managers in the country who invest in the same style. For example, a small cap value manager is compared to the Russell 2000 value index as well as thousands of other small value managers. Only by reporting this level of detail can you identify out-performers and underperformers.

The Tufts University Endowment had an 18% return in 2002. It consisted of 20% fixed income, 27% large cap, 10% small cap, 10% international, 5% private equity, and 28% alternative investments. Individual physician-investors can increasingly achieve this kind of allocation and receive institution-quality reporting through independent investment advisory practices.

Edward Papier is senior vice president of Lexington Advisors, an independent wealth management and investment advisory firm with offices in Boston, New York, and Washington, DC. He welcomes questions or comments at 800-626-1566.