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FPA Journal - Changing Equity Premium Implications for Wealth ...

  1. 1. FPA Journal - Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation by Harold Evensky, CFP The wealth management investment model of diversified multi-asset-class/style portfolios, implemented by selecting style-consistent active managers, has served wealth manager clients well. However, during the last few years, there has been a growing consensus that future market returns will be less than long-term historical averages. To date, there has been no discussion regarding the implications of lower market returns on the wealth management investment model. This paper concludes that in an environment of lower market returns, the current model may no longer serve either clients or practitioners well. As a consequence, wealth managers should revisit and possibly revise many investment aspects of their current practice. Harold Evensky, CFP, is chairman of Evensky, Brown & Katz in Coral Gables, Florida, and is the author of Wealth Management, published by McGraw/Hill. He is chair of the TIAA-CREF Institute Financial Advisor Advisory Board and has been a principal in his own broker/dealer firm. "We don’t like their sound and guitar music is on the way out." —Decca Recording Company, regarding the Beatles, 1962 During the last few years, there has been an increasing focus of investment research, articles and programs on the subject of the equity premium and the implications for future market returns.1 A significant number of academics and money managers have concluded that future returns will be significantly less than those of the last few decades. In fact, there seems to be a consensus that future market returns will be less than the 11 percent average of the last 70- plus years.2 Conversations with many leading wealth managers, and a review of recent professional financial planning publications, lead the author to conclude that practitioners generally agree.3 During this same period, the financial planning specialty known as wealth management has become the predominant model for retail financial services firms. The investment process wealth managers currently use for designing and implementing portfolio strategies for their clients has been modeled after investment policy design and implementation strategies developed for large tax-exempt institutional clients. This has led to the design of multi-asset-class/style portfolios, implemented by selecting style-consistent active managers.4 In spite of the widespread discussion about the equity premium and a significant consensus that future equity returns will be modest by long-term historical standards, there has been little consideration given to the impact of lower returns on the profession of wealth management and the clients of wealth managers. This paper specifically addresses the impact on investment practices. It makes the argument that, although traditional wealth management investment practice has been an effective model for both practitioners and their clients, this approach may no longer serve either clients or practitioners well in an environment of lower market returns. As a consequence, wealth managers should revisit and possibly revise many investment aspects of their current practice. Most significantly, this paper concludes that the performance drag of fees and taxes in a low-return environment so seriously undermine the portfolio alpha, provided by current wealth management investment practices, that a new investment model(s) must be developed. Background Many financial planning professionals, as well as many of their financial services brethren, such as accountants, insurance specialists and money managers, have become specialists in wealth management. Wealth managers combine, for the benefit of their clients, knowledge of the process of financial planning with the intellectual capital of the pioneers of modern finance. In particular, many wealth managers have incorporated a number of key concepts of modern investment theory (Graham, Markowitz, Sharpe and Brinson) into investment planning for their clients. These concepts, such as mean variance optimization, efficient frontiers and extensive diversification, have been accepted as "gospel" by most of the planning profession. Two of the profession’s most successful books have 2002_Issues/jfp0602 (1 of 14)
  2. 2. FPA Journal - Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation focused on these issues (Gibson 2000, Evensky 1997). Summing up the general consensus, Lynn Hopewell wrote in 1995, "The essence of asset management is investment policy, portfolio design and performance measurement. The technical tools are modern portfolio theory and statistics." (Hopewell 1995) Not only has today’s wealth manager been taught that the professionally correct process for portfolio design is the development of a sound and well diversified investment policy, modern law (ERISA, the Third Restatement of Trusts, Uniform Prudent Investor Act) mandates adherence to this process. Leveraging off the experience of large institutional investment managers and consultants to implement these concepts, the practical result has been a professional commitment to the development and management of a diversified, multi-asset-class/style portfolio typically implemented with multiple active managers. For the most part, the clients of wealth managers have been well served—until now. Today, wealth managers are faced with the unnerving prospect that the institutional conventions of portfolio design may soon be reduced to nothing more than a shimmering mirage—at least for portfolios that hold taxable investments. The prospect of a substantially diminished equity-risk premium is a "malignancy" that threatens the very foundations of contemporary wealth management. Equity-Risk Premium Academic and practitioner discussions, symposia and articles related to the equity-risk premium5 have been common over the last few decades.6 As equity returns not only have been high, they have usually far outperformed fixed- income alternatives, these discussions have been of little practical import.7 The public, encouraged by financial pornography,8 has come to depend on returns far in excess of any reasonable expectations. During the mid-’90s, this euphoria was epitomized by the oft-touted reference to "New Era" economics. Wealth managers who rejected this mania tended to feel righteous (especially during the most recent bear market) in their use of a "conservative" equity premium in the range of seven to nine percent. That feeling has been supported by market reality during the last two years, but it may be time to revisit the definition of "conservative." During the last few years, there has been a change in discussions regarding the equity premium. Rather than focus on the "why," commentators have emphasized the "what"—that is, what can we expect the equity premium to be in the future? Somewhat unique in the annals of investment debates, the conclusions of the participants—practitioner and academic, efficient and inefficient market proponents—tend to cluster in a narrow range well below the traditionally assumed seven to nine percent. Today’s range, as estimated by a number of respected academics and practitioners (see Table 1), was most recently summarized by Reichenstein (2001). Similar conclusions were reached by the participants in a special symposium recently held by the TIAA-CREF Institute and AIMR. The participants9 in this "by invitation only" program uniformly concluded that the future equity premium will be less than the historical premium. The consensus premium was zero percent to four percent (Veres 2001). An expectation of a lower equity premium is not limited to academics and academic-oriented practitioners. For example, a recent Deutsche study (2001) concluded "...brings the real return to the 3.2 percent range, assuming that current valuation levels hold (Deutsche’s emphasis). Particular aggressive growth assumptions could stretch real equity returns to perhaps 4.2 percent." 2002_Issues/jfp0602 (2 of 14)
  3. 3. FPA Journal - Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation In a recent article, Bernstein and Arnott succinctly framed today’s reality: "If we examine the historical record, neither the eight percent real return nor the five percent risk premium for stocks relative to government bonds has ever been a realistic expectation, except from major market bottoms or at times of crisis such as wartime. Nor most assuredly, are those reasonable expectations today" (Bernstein 2002). Practitioners who ignore this warning and eschew the likelihood of lower future market returns obviously need not concern themselves with potential consequences. However, although this paper’s primary focus is on the implications for portfolio design and management, for those who believe that the future will "see" a lower equity premium, there are multiple and monumental other implications noted in Appendix A. One of the most significant, and the focus of the balance of this paper, is the implication for wealth management portfolio design and implementation. Implications for Portfolio Design and Implementation Today, wealth managers, as well as most financial services firms, provide services based on the premise that "a major function of the wealth manager is to advise clients on the allocation of their investments across different asset classes" (Evensky 1997). As noted earlier, this conclusion was based on a long history of investment research, legal mandates and institutional experience. The primary investment strategy used by many wealth managers has been the adoption of an institutional strategy based on a multi-asset-class/style allocation derived from the use of a mean variance optimization (MVO) process. Alternative strategies include life cycle, multiple scenario, judgmental intuition and third-party models. All of these have, in common with the MVO solution, a policy that incorporates multiple managers in numerous asset classes and styles.10 The process. Policy design requires, either implicitly or explicitly, a number of basic parameters: ● Asset classes/styles to be considered for inclusion in the final policy ● Rebalance parameters ● "Assumption set"—that is, specific market expectations11 ● A system for applying the policy allocations to the selected asset classes/styles12 The result. The typical end result is a portfolio with assets divided among many independent money managers. Once the initial policy has been implemented, portfolio management mandates periodic trades. In addition to those triggered by the rebalancing policy, trades are triggered by manager changes (due to unacceptable performance, style drift or personnel changes, for example), investment policy changes (such as changing market expectations or changes in acceptable asset classes/styles), client needs (unanticipated liquidity requirements, behavioral responses to volatile markets and so on), and fund actions (such as policy changes or extraordinary taxable distributions). Following are some problems with the current model: ● Clients are subject to numerous forms of taxation: ordinary, short-term and long-term capital gains, and alternative minimum tax (AMT). ● Clients’ taxes are influenced by their unique cash flow and tax basis. ● Clients have numerous "pockets" of investments: taxable, tax deferred and tax free. ● Tax payments do not necessarily come from the portfolio generating the taxable event. "Portfolios don’t pay taxes, people do" (Stein 1999). ● The taxable world is multiperiod. Investment decisions in one period have effects on after-tax returns in subsequent periods. This multiperiod nature of portfolio management results in contingent future tax liabilities (Poterba 1999). ● The traditional approach to portfolio optimization incorporates the concept of rebalancing. There is an intrinsic contradiction for taxable investors as continuous rebalancing results in continuous exposure to taxes (Korn 2001). ● Viable efficient frontier analysis does not exist on an after-tax basis (Brunel, Alternative 1999). ● Most managers (active and passive) are inherently tax inefficient (Jeffrey 1993). 2002_Issues/jfp0602 (3 of 14)
  4. 4. FPA Journal - Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation ● Independent of the tax efficiency of individual managers, implementation of multi-manager portfolios is inherently tax-inefficient due to the lack of active tax coordination among the managers. In summary, the taxable efficient frontier is three-dimensional—expected return, risk and taxes. Thus, the impact of taxes invalidates the results of a traditional optimization process that ignores taxes (Brunel 1998). Benefit Versus Costs As posed by Jeffrey (1993), the question facing the profession is, "Is your alpha big enough to cover its taxes?" The answer may have been yes in 1993, but today it is probably no. This paper develops a benefit evaluation model for the use of practitioners in answering Jeffrey’s question. The following discussion describes the significant elements incorporated in this model. It also suggests the basis for estimates that the author considers appropriate for the model’s input. Evaluation of the benefit. Although alpha is typically used to denote active manager outperformance, for purpose of this paper it is used to describe the value added by the active portfolio management of the wealth manager. To evaluate this wealth manager "alpha" benefit, the author designed a "typical" multi-asset/class portfolio with "representative" multi-manager implementation. The design criteria for the "typical" portfolio and the "representative" multi-managers are covered in Appendix B. (Jeffrey’s query ignores the potential benefit of risk reduction associated with diversification. However, a literature review provided no support for the argument that the risk reduction associated with a wealth management model of a diversified portfolio significantly reduced portfolio risk relative to a diversified market portfolio. A mean variance optimization based on Ibbotson data from January 1975 (the earliest that style data was available) through 2000 indicated a market return of 16.1 percent with a standard deviation of 17.5, as compared with a standard deviation of 15.5 for a multi-asset-class/style portfolio providing the same return—obviously a very modest risk reduction benefit. Further, as noted in the conclusion of this paper, alternative tax efficient models (such as core and tactical satellite) may include strategies that incorporate risk reduction elements. The burden of proof is on the advisor who makes the argument that risk reduction benefits outweigh tax and expense drag.) An additional factor required to evaluate the benefit of active portfolio management is the net excess portfolio return provided to an investor by diversification among asset classes and styles and active management in the implementation of these allocations. This factor will be referred to as the wealth manager factor (WMF). To quantify this factor, the author first considered whether it was reasonable to expect the factor to be an absolute value (for example, 2 percent) or some relative value (for example, 20 percent of the market return). A literature review provided no substantive guidance on this issue. Although the author’s preliminary development of a WMF was based on the assumption that the value added by active management would be a function of the general market return (relative), earlier reviewers challenged this notion, arguing that managers can add absolute value, independent of general market returns. Consequently, two alternative benefit evaluation models were developed: one based on an absolute portfolio factor and a second based on a relative factor. The absolute is designated as the Absolute WMF and the relative, measured as the excess portfolio return as a percentage of the market return (S&P 500), is designated the Relative WMF. Unfortunately, estimating these factors proved problematical. A literature review found no research quantifying either absolute or relative alpha attributable to wealth management, although recent data related to individual fund and manager alphas suggests a range of 0 to 2.5 percent. For example, de Silva (2001) reported that the average alpha of the 25 largest actively managed U.S. equity funds from 1991–2000 was –0.80 percent; the top quartile was 1.7 percent and the single best provided 2.63 percent. Using the Typical Portfolio allocations and Representative WMF described in Appendix B, the Absolute WMF was estimated to be an absolute 1.9 percent and the Relative WMF was estimated to be 9.5 percent of the market return. Evaluation of the costs. Clients incur five primary costs associated with the investment advice and management services provided by wealth managers: the wealth manager’s fee, custodial costs, transaction costs, and investment 2002_Issues/jfp0602 (4 of 14)
  5. 5. FPA Journal - Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation manager fees and taxes. A significant portion of the value added by the wealth manager may be attributed to his or her management of the following elements (Appendix B). Transaction costs (commissions, bid/ask spread and market impact). As most advisors implement portfolio investments with institutional management, transaction costs are competitive with those incurred by larger institutions. As a consequence, assuming reasonable due diligence on the part of the wealth manager in selecting money managers, the only controllable transaction cost is related to turnover. Using 0.5 percent per dollar traded, as an estimate of the cost of a transaction, (Apelfeld 1996, Bogle, Jr. 1997, Berkowitz 2001), a reasonable estimate for the annual trading costs of a representative portfolio is 0.45 percent.13 Other costs. These are the costs, other than transaction costs, directly related to the management of the portfolio assets. They can be separated into those costs associated with all forms of management and those associated with active management, such as active manager fees and research. Tax drag (effective tax rate or tax efficiency). This is the average annual percentage of total return paid in taxes. Reviewing the available research, the author considers 20 percent to be a conservative estimate. Other factors. There are numerous non-quantifiable, unsystematic factors that might significantly exacerbate tax drag. They should, however, be considered by practitioners when setting a threshold alpha factor benchmark to determine if the traditional investment model can cover its costs. The most important of these factors include ● Manager replacement. ● Rebalancing. ● The use of mutual fund managers often results in unanticipated and unpleasant year-end tax consequences. ● Client behavior—clients do not necessarily make their investment decisions in accordance with classical economic theory. Clients often trigger portfolio transactions that are neither short-term tax efficient nor in their long-term economic interest. ● Tax "efficient" managers may not remain tax efficient. Benefit Evaluation Models The evaluation model examples shown in Table 2 are designed to answer Jeffrey’s question, "Is your alpha big enough to cover its taxes?" 2002_Issues/jfp0602 (5 of 14)
  6. 6. FPA Journal - Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation Although investors may focus on total return, professionals recognize that the resources available to meet their clients’ financial goals are net after-tax real returns. A measurement of a wealth manager’s active portfolio management contribution to the client’s financial goals, annualized over a market cycle, can be calculated as in the absolute alpha evaluation model. This analysis demonstrates that a reduction in market return may significantly reduce the portfolio alpha provided by traditional active portfolio wealth management. The author evaluated a wide range of additional outcomes; Appendix C provides a representative summary of the results. In addition, the author ran Monte Carlo simulations and concluded that there would be less than a 15 percent probability of exceeding even a modest 1 percent alpha benchmark. Alternative Models This analysis demonstrates that, in a world of lower premia, the wealth manager’s traditional multi-asset class/style, multi-manager model is no longer appropriate for most taxable accounts. The question wealth managers must address is, what issues need to be considered in developing a new model? The key to a successful investment model 2002_Issues/jfp0602 (6 of 14)
  7. 7. FPA Journal - Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation will be one focused on an optimal strategy instead of an optimal portfolio (Brunel 1999). Research demonstrates that there are potential significant after-tax alpha-enhancing strategies (Arnott 2001; Brunel July–August 1999, Spring 1999); Chincarini 2001; Stein 1999, 2000, 2001). These strategies incorporate elements of option theory, tax policy and benchmark tracking management. After-tax alpha also may be derived from an effective use of the unique aspects of an individual client’s circumstances. One of the most promising investment models is "core and tactical satellite." This model allocates a significant portion of the equity investment to a passive tax- managed core (possibly with style or class tilt). The balance of the allocation is made to satellite managers. These satellite managers may be given broad mandates and the strategy may incorporate tactical changes in satellite managers. The total portfolio is managed to be dynamically efficient in a taxable client’s three-dimensional investment space (return, risk and taxes). This may become the basic wealth manager investment model for the future. Conclusion Wealth managers do not have the luxury of telling their clients, "The future is uncertain. I have no idea what returns will be." Our clients’ investments exist, their allocations exist and their goals exist. Our clients live in a real world and they have a finite time horizon. While academics may theorize and strategists pontificate, wealth managers must make timely and specific recommendations regarding the allocation and management of their clients’ portfolios. The results of these recommendations will have significant influence on the probability of clients’ ability to meet their goals. The lessons of Markowitz and the importance of investment policy as demonstrated by Brinson remain valid today. However, the multi-asset class, multi-manager investment policy model, developed for large tax-exempt institutional clients and adopted for wealth management advisors, may no longer be appropriate for many taxable clients. The current model is inherently tax-oblivious and at best tax-inefficient. It also results in significant operational costs associated with the effort to add portfolio alpha. In the future, it is unlikely that the portfolio alpha associated with current wealth management investment practices will cover the drag of taxes and expenses. Myopia is dangerous for both our practices and our clients’ well-being. It is imperative that wealth managers revisit some of their most closely held investment beliefs and ask if they are still applicable today. Many may no longer be appropriate. Endnotes 1. The term "future" is generally only vaguely defined in these discussions; however, even those commentators at the short end of the time scale are projecting at least five years out. Most refer to horizons of ten years-plus. 2. Roger Ibbotson is a notable exception. He continues to project return premiums consistent with the historical data. 3. As an example, an informal poll of a number of Alpha Group members (a study group of experienced practitioners) indicated a 7.5 percent to 9 percent range for total market return expectations. 4. In selecting an asset class and style universe, wealth managers tend to mimic the universe reflected in the Morningstar style boxes and categories. Although it is unlikely that a wealth manager will use all, or even most, of these class/styles for a single client, a policy will typically include at least six and rarely less than four asset classes/styles. 5. When discussing equity-risk premium, often used interchangeably with "equity premium," the semantics can get confusing. Generally, "risk premium" refers to the asset class return less the relevant "safe rate" (typically T-bills); however, this definition is not universal in usage. This author uses the traditional T-bill referenced definition for both expressions. Given the historical relationship between T-bill return and inflation, a reasonable estimate for the conversion between the equity-risk premium (ERP) and real equity premium (REP) is REP = ERP + 1 percent. 6. Representative current examples include r Arnott, Robert and Ronald J. Ryan, "The Death of the Risk Premium," Journal of Portfolio Management, Summer 2001. r Asness, Clifford, "Bubble Logic, Or How to Learn to Stop Worrying and Love the Bull," December 2002_Issues/jfp0602 (7 of 14)
  8. 8. FPA Journal - Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation 2000. r Jones, Charles and Jack Wilson, "Stock Returns in the 1990s: Implication for the Future," Journal of Private Portfolio Management, Spring 2000. r Reichenstein, Bill, "Prospects for Long-Run Stock Returns: Implications for Individual Investors," TIAA- CREF Institute Research. r Rekenthaler, John, "Rethinking Stock Market Returns: Are Clients Being Promised Too Much?" Journal of Financial Planning, October 2000. r Shiller, Robert, Irrational Exuberance, 2000. r Siegal, Jeremy, "The Shrinking Risk Premium," Journal of Portfolio Management, Fall 1999. 7. I stand corrected. Cliff Asness kindly agreed to review my paper and he noted, regarding this statement, "Hey! I enjoyed them…" 8. A term coined by Rex Sinquifield of DFA to describe the unsubstantiated (and generally unsound) marketing hype often found in publications and advertisements directed at the retail investor. 9. The group (11/2001) included Stephen Ross, MIT; Roger Ibbotson and Robert Shiller, Yale University; Campbell Harvey and Ravi Bansal, Duke University; John Campbell, Harvard University; Richard Thaler and Rajneesh Mehra, University of Chicago; Clifford Asness, AQR Capital Management; Jeremy Siegel, Wharton School of Business; Robert Arnott, 1st Quadrant; Brad Cornell, UCLA; Marty Leibowitz, TIAA-CREF; and Brett Hammond, TIAA-CREF. 10. For the purposes of this discussion, the focus will be on the domestic equity allocation. Narrowing the discussion to this sub-component somewhat simplifies an already complex discussion, but the issues, observations, processes and conclusions are uniformly applicable to any portfolio construction. 11. Advisors and academics tend to use an assumption set influenced by historical returns recorded in Ibbotson data. Based on this data, total return expectations cluster around 11 percent for equity and 5 percent for bonds. In real returns, the related assumption set would be eight percent for stock and three percent for bonds. Recent professional literature suggests that these expectations are in the "conservative" range of expectations relative to those used by many professionals (Rekenthaler 2000). 12. Because a core competency of a wealth manager is money manager selection, wealth managers are sensitive to the unique risk associated with individual money managers. As a consequence, it is common to diversify allocations in a specific asset class/style between two or more managers. The result is a multi-manager portfolio. 13. Fortin (1996) found that brokerage cost alone accounted for 31 basis points. 14. Performance and inflation data from the Ibbotson 20-year series through 2000; other assumptions are detailed in this paper’s prior discussion. 15. "As Budget Deficits Loom, Many Promises, Programs Could Suffer. Social Security Is Vulnerable As Huge 10- Year Surplus Contracts by $4 billion," The Wall Street Journal, January 24, 2002. 16. Jonathan Clements recently wrote in The Wall Street Journal (2001), "Make no mistake: Like them or not, immediate-variable annuities are going to be huge." 17. As noted earlier, this discussion is focused on the domestic equity allocation of the client’s portfolio. References Apelfeld, Roberto. Gordon Fowler, Jr., and James Gordon, Jr. "Tax-Aware Equity Investing." Journal of Portfolio Management, Winter 1996. Arnott, Robert, Andrew Berkin and Jia Ye. "Loss Harvesting: What’s It Worth to the Taxable Investor?" Journal of Wealth Management, Spring 2001. Arnott, Robert, Andrew Berkin and Jia Ye. "The Management and Mismanagement of Taxable Assets." Journal of Portfolio Management, Spring 2001. Berkowitz, Stephen and Dennis Logue. "Transaction Costs." Journal of Portfolio Management, Winter 2001. Bogle, Jr., John. "‘The Destruction of Alpha’ Transaction Costs and The Growth of Assets." Presentation, March 10, 1997. 2002_Issues/jfp0602 (8 of 14)
  9. 9. FPA Journal - Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation Brunel, Jean. "A Tax-Aware Approach to the Management of Multiasset Class Portfolios." Journal of Private Portfolio Management, Spring 1999. Brunel, Jean. "The Role of Alternative Assets in Tax-Efficient Portfolio Construction." Journal of Portfolio Management, Spring 1999. Brunel, Jean. "Why Should Taxable Investors Be Cautious When Using Traditional Efficient Frontier Tools?" Journal of Portfolio Management, Winter 1998. Bernstein, Peter and Robert Arnott. "Setting Realistic Expectations." Investment News, January 21, 2002. Chincarini, Ludwig and Daehwan Kim. "The Advantages of Tax-Managed Investing," Journal of Portfolio Management, Fall 2001 Clement, Jonathan. "New Annuity Beckons to Aging Boomers, Wall Street Journal, October 23, 2001. de Silva, Harindra, Steven Sapara and Steven Thorley. "Return Dispersion and Active Management." AIMR, September/October 2001. Deutsche Asset Management. "The Equity Risk Premium." Global Outlook, May 2001. Evensky, Harold. Wealth Management, McGraw Hill, 1997. Fortin, Rich and Stuart Michelson. "Mutual Fund Trading Costs," Presentation to the Academy of Financial Services, October 1996. Gibson, Roger. Asset Allocation: Balancing Financial Risk, McGraw Hill, 2000. Hopewell, Lynn. Journal of Financial Planning, October 1995. Ibbotson Associates, Stocks, Bonds, Bills and Inflation 2000 Yearbook. Jeffrey, Robert and Bob Arnott. "Is Your Alpha Big Enough to Cover Its Taxes?" Journal of Portfolio Management, Spring 1993. Jeffrey, Robert. "Tax-Efficient Investing Is Easier Said Than Done." Journal of Wealth Management, Spring 2001. Poterba, James. "Unrealized Capital Gains and the Measurement of After-Tax Portfolio Performance." Journal of Private Portfolio Management, Spring 1999. Reichenstein, William. "Prospects for Long-Run Stock Returns: Implications for Individual Investors." TIAA-CREF Institute Research, September 1, 2001. Reinhart, Len and Joseph Doyle, Jr. "The Impact of Taxes on Investment Returns." Personal Financial Planning, March/April 1999. Rekenthaler, John. "Rethinking Stock Market Returns: Are Clients Being Promised Too Much?" Journal of Financial Planning, October 2000. Ricks, William and Austin Sevilla. "Evolving Risks and the Market Environment," presentation at AXA Rosenberg’s 2001 Global Client Conference, October 22, 2001. Stein, David. "Equity Portfolio Structure and Design in the Presence of Taxes," Journal of Wealth Management, Fall 2001. Stein, David and Premkumar Narasimhan. "Of Passive and Active Equity Portfolios in the Presence of Taxes." Journal 2002_Issues/jfp0602 (9 of 14)
  10. 10. FPA Journal - Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation of Private Portfolio Management, Fall 1999. Stein, David, Andrew Siegel, Premkumar Narasimhan and Charles Appeadu. "Diversification in the Presence of Taxes." Journal of Portfolio Management, Fall 2000. Stein, David. "Cap-Weighted Indexing Revisited: Indexing is Not a Momentum Play," Journal of Wealth Management, Winter 2001. Veres, Robert. "Risky Premium." Inside Information, December 2001. Appendix A Other Implications There are numerous wealth management implications for a reduced equity premium in addition to those affecting portfolio design and management. The following inclued some of the most important. Implications for our clients' long-term well-being. As reflected in Table A-1, a reduction in the equity and related bond premium would significantly increase the allocation to equities required to maintain real returns. Many clients, particularly those currently retired or nearing retirement, are unaware that they may face the dilemma of choosing between significantly increasing their equity exposure or reducing their return expectations (and potentially their standard of living). Implications for selection of investment vehicles and strategies. The difficulty clients may face in their ability to meet financial retirement goals due to the impact of reduced equity returns will be exacerbated by a number of other factors. These include increased life expectancy, reduced defined benefit pension benefits and, potentially, reduced Social Security income.15 As a consequence, wealth managers need to consider expanding their universe of investment alternatives and strategies. The single most important "new" investment vehicle may be reconsideration of the universe of insurance investment products, particularly payout annuities (these vehicles are generally ignored by a significant portion of the wealth manager profession). Due to the potential significant survivorship return and the certainty of cash flow, the author believes that payout annuities will become one of the most significant investment vehicle/strategies of the future.16 Implications for wealth manager compensation. One possible consequence of lower returns may be a market shift in the compensation strategy of financial services firms from an asset-based to a retainer (value added) fee. Appendix B Typical Portfolio To estimate the expected return and costs associated with the implementation and management of a "typical" portfolio17 it is necessary to make a number of assumptions. The tables below shows the assumptions used in this 2002_Issues/jfp0602 (10 of 14)
  11. 11. FPA Journal - Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation paper: Attributes Recognizing that wealth managers pride themselves on their ability to select superior management, the design of a "typical" portfolio was constructed around managers with demonstrable superior performance records. This universe of "representative" managers was selected by screening (Morningstar Principia Pro) each asset class/style for those distinct portfolio managers in the specified Morningstar category who performed in the top quartile for both three and five years. The key portfolio attributes shown in Table B-2 were derived from the results of that search. Trading Costs Percentage trading costs can be calculated by the simple formula: Trading costs percentage = 2002_Issues/jfp0602 (11 of 14)
  12. 12. FPA Journal - Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation Turnover * Cost/Dollar Traded See Table B-3 for estimated trading costs of a typical portfolio. Other Expenses Other expenses include those fees associated with the management of a portfolio not included in trading costs (such as money management and custodial fees). In the Morningstar database, these fees are reflected in the category "expenses." An estimate of the fees specifically related to active management (referred to as "active" expenses) can be derived by subtracting the total expenses of an appropriate index fund (referred to as "passive" expenses) from the total reported for the active manager. For purposes of this analysis, the Vanguard S&P 500 was selected as the index manager because it is representative of the "market" portfolio benchmark used in this paper. (See Table B-4) Tax Drag: Active and Passive Management The following are representative examples of tax efficiency estimates. These estimates support the use of an estimated 80 percent tax efficiency. ● Reinhart (1999), using TR Price and Morningstar data, estimated tax efficiencies as Growth 82.5 percent, 2002_Issues/jfp0602 (12 of 14)
  13. 13. FPA Journal - Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation Equity Income 78.7 percent, Growth & Income 79.1 percent and Small Company 84.2 percent. ● Using a statistical approach, Brunel (AIMR) ran a ten-year Monte Carlo simulation for a simple world of four asset classes and two portfolios with equal expected returns of 9 percent and standard deviations of 14 percent and 20 percent. The simulation results indicated tax efficiencies of 74 percent and 79 percent. ● Contrary to popular belief and frequent media assertions, index management is not particularly tax efficient. In fact, as shown in Table B-5, the only relatively tax-efficient passive indexes listed by Morningstar are those very highly correlated with the S&P 500. The average tax efficiency of those index funds with an R-squared (relative to the S&P 500) of 98 or less was 65 percent. The weighted tax efficiency of a portfolio mirroring the typical portfolio and composed of the index funds listed in Table B-5 would be 75 percent. Table B-6 compares absolute and relative wealth manager alpha. Appendix C Benefit Analysis Scenario Examples The scenarios in Table C-1, comparing the portfolio alpha of active wealth management with a passive market portfolio, are included to demonstrate there is little likelihood of value added, for taxable clients, by a traditional wealth management multi-asset-class/ style, multi-manager model in a low return environment. Although estimates, based on optimistic assumptions, for Absolute WMA ranged from 1.9 percent to 2.6 percent, and the single estimate for the 2002_Issues/jfp0602 (13 of 14)
  14. 14. FPA Journal - Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation Relative WMA was just under 10 percent, the following scenarios anticipate the behavioral heuristic of overconfidence (that is, some readers may believe in their ability to add greater alpha). As a consequence these scenarios assume an Absolute WMA of 3 percent and a Relative WMA ranging from 20 to 30 percent. As will be noted, even with these assumptions the results provide no support for continuing with the current wealth management investment model. Readers can simulate their own scenarios using the evaluation model formulas described in the text. 2002_Issues/jfp0602 (14 of 14)]

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