Investing Like an Institution

Investing Like an Institution Edited by: Douglas W. Evans, CFA, CIMA Senior Managing Director, Asset Management Thomas Hainlin, CFA Asset Allocation Strategist In This White Paper: Part One The Psychological Considerations 1 Part Two Financial Considerations 2 Asset Allocation and Portfolio Construction 2 Money Manager Selection 3 The Next Step 4

Investing Like an Institution Part One The Psychological Considerations As an investor with substantial assets looking to manage your wealth as effectively as possible, it s best to start by considering the ancient Greek maxim commonly credited to Socrates: Know thyself. The investment landscape is broadly divided among three types of investors: retail (or mass affluent), high-net-worth and ultra-high-net-worth (or affluent) and institutional. The mass affluent, high-net-worth and ultra-high-net-worth segments, often defined as investors with fewer than $5 million in assets and $5 25 million in assets, respectively, comprise the vast majority of the investing public. Institutions, by contrast, consist of the country s largest corporations and their pension funds, government funds, Taft-Hartley funds, foundations, endowments and other organizations that often must oversee hundreds of millions of dollars in investment capital each year. Understanding where you fit within this landscape is one of the most important considerations you ll make as an investor. By adopting the appropriate investor profile one that reflects the specific needs and demands you face given your level of wealth and other factors you ll have the peace of mind knowing that you ve put yourself in the best possible position to build and maintain an investment plan that meets your full range of objectives. The most successful investors tend to be those who recognize what type of investor they are and use that knowledge to guide their investing, says Dr. Richard Geist, president of The Institute of Psychology and Investing and co-author of The Psychology of Investing. Because of your substantial portfolio, your own investor profile is virtually institutional in terms of the quality of asset management you require. Indeed, the largest institutions and the wealthiest Americans share a number of important investor characteristics, including: Fiduciary duties. Institutions, as well as trustees and guardians of family wealth, are held to a significantly higher standard of responsibility when it comes to asset management because both groups are often legally obligated to make prudent financial decisions on behalf of all the beneficiaries they serve. For wealthy families, meeting these obligations can prove especially challenging. The demands of various family members may cause conflicts over what constitutes a prudent approach, while the sheer number of investments and money managers available to affluent investors requires thorough evaluation techniques to identify the most appropriate investment solutions. Multigenerational needs. The legacy capital that wealthy families invest often must provide for today s beneficiaries (including family members and charitable organizations) as well as endure for multiple future generations, just as pension plans and foundations must manage to meet current and future liabilities. Both groups therefore face the challenge of incorporating a disciplined investment process that will allow them to make financial decisions that strike a balance between the needs of today and those of tomorrow. Control. Institutions and affluent investors alike must retain significant control over the investment process in order to manage significant assets effectively and fulfill fiduciary duties. Systems to maintain a high degree of due diligence must be designed and integrated into the investment program. These systems must ensure that the investments and financial professionals used are consistently working to meet the institution s or the individual s specific goals. Global opportunity set. Institutions and wealthy private investors view the entire global set of available investment solutions, those within the U.S. and other developed economies (such as Canada, U.K., Continental Europe, Japan and Australia), as well as those in emerging markets in Asia, Eastern Europe, and Latin America, and even frontier regions such as the Middle East and Africa. Sophisticated investment requirements. Institutions and wealthy private investors have access to a myriad of advanced investment solutions that are simply not available to, or practical for, retail investors with smaller sums. These solutions, such as real assets (real estate, commodities, timberland), hedge funds, and investments in private capital (debt as well as equity), can be combined with traditional, core strategies to create highly customized portfolios that enable ultra-affluent investors to tailor their investment portfolios to their specific objectives. Comprehensive view of risk. Because of their unique strategies and product design, investing in real assets and complementary strategies, such as hedge funds and private capital, may entail factors that go beyond performance volatility and market sensitivity in assessing the risk of a permanent loss of investment capital. Therefore, institutions and wealthy private investors require a more holistic view of risk, one that examines factors such as capital control, transparency, concentration, leverage, and operational risks when considering making an individual investment within the context of the overall portfolio. Investing Like an Institution 1

Superior manager requirements. When taking responsibility for many millions of dollars in assets, the need for disciplined investment managers with superior capabilities becomes paramount. Many affluent investors have complex concerns regarding tax sensitivity, concentrated stock positions and illiquid assets (such as family-owned businesses) that demand a level of management experience not found among those firms serving more traditional investors. In short, the advanced needs and challenges you face as an ultra-high-net-worth investor require investment consulting strategies that are equally advanced. A mass market approach to asset management is not likely to provide you with such strategies, nor is an enhanced, or super-sized retail or high-net-worth solution appropriate. Rather, institutional quality investors require a solution built from the ground up and designed specifically to meet their unique profile and needs. Investors with significant assets must recognize that their financial position requires them to be treated like the world s largest institutions. Part Two Financial Considerations Once you see that your own investor characteristics are akin to those of the largest companies and endowments, you must ask the question: What does it mean to invest like an institution? Institutions manage their wealth in fundamentally different ways than other types of investors. Most significantly, they adopt disciplined investment processes based on a combination of accepted academic investment theory and sophisticated portfolio construction techniques designed to remove emotion from all investment decisions and replace it with the logic needed to make prudent, rational choices. What s more, institutions document each step in the process and every investment decision in a formal policy statement that sets forth all aspects of their wealth management plans. This gives institutions a comprehensive road map to guide their investing and provides the control necessary to ensure their portfolio strategies remain effective over many decades. Institutional investors use a rational framework of rules and hierarchies to manage their assets most effectively. This enables them to stay disciplined and focused, avoid getting caught up in the noise of the marketplace, and satisfy their fiduciary duties. Essentially, institutions treat investing in the same way that successful business owners approach their enterprises: they incorporate the right systems that enable them to make the smartest possible choices and maximize their chances of success. Often, institutions hire experienced money managers to assist their investment committees with asset allocation (establishing strategic targets and identifying shorter-term tactical, and longer-term thematic opportunities), portfolio construction, manager research and performance reporting. To see how an institutionalquality approach works, consider two components of the investment consulting process that differentiate the world s most successful institutions from the masses portfolio construction and money manager selection. Asset Allocation and Portfolio Construction Most investors seek to build portfolios that achieve relatively arbitrary goals, such as outperforming the S&P 500. To that end, they spend a significant amount of time attempting to find the specific stocks, funds or other vehicles that they think will enable them to achieve their objectives and often become frustrated when those investments fail to live up to their expectations. These investors make two crucial mistakes: 1) they fail to consider the appropriate goals and match their portfolio to meet those goals, and, thus, 2) they spend too much time focused on the wrong investment decisions. Institutions, by contrast, approach portfolio construction in a wholly different way. Their process begins by carefully determining specific goals that reflect their unique situations and the objectives they must achieve to satisfy their current and future financial responsibilities. This high-level analysis clarifies important issues such as: The overall purpose of the capital The amount of capital to be invested (versus capital being held in liquidity reserves) The time horizon of the investment capital Other liquidity constraints to meet changing requirements and adapt to changing circumstances Current and future spending requirements Expenses Inflation and other economic and capital markets assumptions The institutions goal: construct portfolios capable of delivering a return that will cover management expenses, outpace inflation, satisfy current income needs and continue to grow the assets at the necessary pace to provide for the capital s eventual beneficiaries. This gives institutions a clear definition of what their investing is trying to achieve and provides the basis for assessing if those objectives are being met. 2 Investing Like an Institution

Only after these goals are clearly formalized and communicated do institutions begin constructing portfolios. Here again, institutions avoid one of the most common mistakes of individual investors focusing only on which specific stocks, bonds, managers, funds or other securities to buy. Instead, they incorporate a Nobel Prize-winning body of investment research known as Modern Portfolio Theory, which shows that the most important determinant of portfolio performance comes not from the specific securities selected or how well investors time their purchases and sales, but by how assets are divided among broad asset categories and styles (such as large-cap growth stocks, international bonds and so on). Institutional investors therefore ask two questions that many investors overlook: Which asset classes should I choose and how much of each asset class should I hold? Using Modern Portfolio Theory and advanced portfolio optimization techniques, institutions shift their focus from analyzing the characteristics of individual securities toward examining the makeup of the whole portfolio and how it can be managed optimally in terms of risk and reward. By identifying the unique characteristics of each asset class and determining how to combine them in the most effective way, institutions are able to build portfolios that generate the best possible return for a given level of risk. These combinations are known as efficient portfolios, and the collection of these portfolios makes up the efficient frontier. (See chart below.) In addition, sophisticated portfolio construction techniques allow institutions to go beyond the efficient frontier by incorporating a more comprehensive, multidimensional view of risk and its consumption in pursuit of investment goals. When constructing an optimal investment portfolio, they consider relevant factors such as capital structure (e.g., senior secured debt, subordinated unsecured debt, preferred stock, common equity), inflation, credit quality, duration, currency, economic sectors, geographic regions and sub-regions, market capitalization and style as well as performance volatility and market sensitivity captured by Modern Portfolio Theory. Institutions demand that their portfolios be efficient. By contrast, the vast majority of portfolios built by and for retail investors are often inefficient. An inefficient portfolio may generate subpar returns, consume excessive risk (in all of its forms) or both. Abbot Downing (AD) Standard and Specialty Objectives Return (%) 12% 10% 8% 6% 4% 2% AD Standard Objectives AD Specialty Objectives Real Assets Moderate/Conservative Moderate Conservative Fixed Income Liquidity Management Complementary Strategies Equities Aggressive Moderate/Aggressive 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% Risk (Standard Deviation %) Money Manager Selection When selecting the money managers who will be responsible for investing your capital in each asset class, it s easy to get caught up in the dangerous practice of chasing performance. In fact, many individual investors even skip the process of setting objectives and simply assume that the managers who have delivered exceptionally strong returns in the past will continue their winning ways. As a result, they entrust their investment capital to those managers with the most impressive short-term performance. Unfortunately, such performance chasing is an ultimately inferior and unprofitable approach. It is widely accepted that past performance is not necessarily an indicator of future performance. Managers who perform exceptionally well during one market cycle can easily fall behind their peer groups in a subsequent market cycle. Some top performing managers were simply at the right place at the right time. You need to determine how they achieved their results and whether or not they are repeatable. The most sustainable results are those that result from a well-established, deep-rooted investment philosophy. Institutional investors employ systems to guard against performance chasing and identify a select group of managers with the potential to deliver competitive returns from year to year. The goal is not to find the hottest 5 percent of managers, because they tend to take on unnecessary risk and burn out quickly. The institutional approach is to find managers who can effectively navigate through a variety of market cycles. Investing Like an Institution 3

Clearly, returns that fluctuate less from year to year can help ensure you don t lose sleep over your investment portfolio. But Abbot Downing Senior Managing Director of Asset Management, Douglas W. Evans, points out an additional, and profitable, advantage of performance consistency. The more stable a portfolio s results, the more wealth you will build over time. Consider two portfolios with the same expected annual return, but different levels of risk. The portfolio with less volatility will actually generate a higher compound rate of return, resulting in more wealth over the long term. An institutional-quality approach to manager selection offers other benefits that may result in superior wealth management strategies, such as: Access. Institutions have access to a select group of investment managers who exclusively serve large investors with complex financial needs. These institutional-quality managers, unavailable to most individual investors, are among the industry s most experienced, disciplined and successful investors and may employ a wide range of advanced investment approaches to meet the unique demands of individuals, families and organizations with significant assets. A low and transparent cost structure. Institutions recognize that controlling the cost of investing is one of the most effective methods to maximize an investment plan s success. All other factors being equal, a portfolio with a lower cost structure will generate a better return than a high-cost portfolio. Institutional investors therefore fully leverage their considerable size to negotiate access to top managers at lower costs than the typical investor pays for investment management. Furthermore, institutions enjoy complete transparency of their investments cost structures. Unlike many investors, they demand and receive a full description of the expenses their managers charge them, thereby avoiding potential problems such as conflicts of interest and hidden fees. Many ways to travel. Institutions employ a wide variety of investment vehicles in order to gain desired exposures to foreign currency and capital markets when constructing their optimal investment portfolios. Examples include: individual securities; exchange traded notes and funds; mutual funds and separately managed accounts; long-short hedge funds; private capital partnerships; direct investments in debt, equity, or real estate; and, other complementary strategies such as exchange traded allocation, bear market, currency and long-short mutual funds; market-linked notes; options; and forward contracts. Style-specific asset management. Some managers may engage in style drift by shifting from one investment approach to another based on market conditions. A value manager, for example, might start buying growth stocks when such shares are popular with investors. Such a shift can cause your portfolio mix to become inefficient, significantly reducing your returns while increasing your risk. Institutions, however, work only with managers who consistently remain fully invested in their stated investment style. Optimal manager combinations. Just as they do with asset classes, institutional investors combine money managers in optimal ways. For example, a pension plan might hire two managers for its allocation to value stocks one who focuses on shares of distressed companies and another who buys higher-quality, dividend-paying firms. Although both managers invest in value stocks, each one s portfolio will likely look much different from the other s and react differently to market conditions. Result: The diversified combination of managers can generate better returns and lower risk than either one can separately. The Next Step A review of your existing portfolio will help you answer many of the crucial questions you face as an institutional-level investor. Are your assets being managed around specific, quantifiable goals that reflect your unique situation? Is your portfolio structured efficiently to provide you with the highest possible return given your risk tolerance? Do your managers possess the discipline and advanced capabilities necessary to generate consistently strong returns at reasonable costs? If so, you are well positioned to achieve investment success. If, however, your analysis reveals areas for improvement, your next step is to begin adopting the proven investment consulting principles that guide the world s biggest institutions. By building an institutional-quality investment plan, you will maximize your chances of achieving the most important financial objectives for you and your family. 4 Investing Like an Institution

Disclosures Investment Products: NOT FDIC Insured NO Bank Guarantee MAY Lose Value Abbot Downing, a Wells Fargo business, provides products and services through Wells Fargo Bank, N.A., and its various affiliates and subsidiaries. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Your individual allocation may be different than the allocation mentioned here due to your unique individual circumstances, but is targeted to be in the allocation ranges for your objective. The asset allocation referenced in this material may fluctuate based on asset values, portfolio decisions, and account needs. The asset allocation suggestions referenced in this material do not take the place of a comprehensive financial analysis. Past performance does not indicate future results. The value or income associated with a security or an investment may fluctuate. There is always the potential for loss as well as gain. Investments discussed in this report are not insured by the Federal Deposit Insurance Corporation (FDIC) and may be unsuitable for some investors depending on their specific investment objectives and financial position. Real estate investments carry a certain degree of risk and may not be suitable for all investors. Some complementary strategies may be available to pre-qualified investors only. Hedge strategies and private investments may be speculative and involve a high degree of risk. Hedge strategies and private investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. There is no secondary market for the investor s interest in a hedge fund or private equity investment and none is expected to develop. There may be restrictions on transferring interests in a hedge fund or private equity investment. This information is provided for education and illustration purposes only. The information and opinions in this report were prepared by Abbot Downing. Information and opinions have been obtained or derived from information we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Abbot Downing s opinion as of the date of this report and are for general information purposes only. Abbot downing does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. This report is not an offer to buy or sell, or a solicitation of an offer to buy or sell the strategies mentioned. The strategies discussed or recommended in the presentation may be unsuitable for some clients depending on their specific objectives and financial position. Wells Fargo & Company and its affiliates do not provide legal advice. Please consult your legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. 2012 Wells Fargo Bank, N.A. All rights reserved. Member FDIC. A Wells Fargo Business 590144