Active asset allocation may cost you in more ways than one

My first experience with fee-based asset management was in the 1990s with an investment program that practiced “active asset allocation.” I sold it to nearly all my clients and it was a disaster.

The investment program had some cool sales tools that would analyze the performance of different mutual funds over a variety of periods. The goal was twofold: first, to own only top-performing mutual fund managers, and second, to allocate between stocks and bonds to protect assets while providing growth.

The problem was the investment manager was not at all proficient at determining which mutual funds would be the top performers in the subsequent quarters and years. Nor were they capable of determining which asset classes to overweight and which to underweight.

The returns were down while the stock market was soaring, so of course my clients weren’t happy. The investment manager believed, based upon some model, that stocks were overvalued and what my clients were feeling was “contrarian heat.” The clients simply needed to be patient until the thesis was proven out.

Fortunately, I didn’t stick with the program very long and decided that my clients, as well as myself, would all be much better off with a portfolio dominated by index funds without the market timing that was disguised as asset allocation. I lost a few clients during this period but was fortunate that many still stuck with me as I transitioned from an asset manager to a more basic investment approach.

This experience taught me two valuable lessons: One, selling my clients on the value of a specific investment manager would sting badly when (not if) the performance was off. And two, because it’s hard to sit on the sidelines when all your neighbors are making money, clients won’t tolerate “contrarian heat” for long.

Here’s what I’ve witnessed in more recent years. Those firms that use a third party that actively allocates investments to the point of market timing have tremendous attrition when their returns are negative and not aligned with the market. Sure, folks may stick around a year or two, but unless their performance catches up to where it should be, these types of clients will find another advisor.

This is all highly problematic for any advisor who's planning on selling their firm. That’s because when a firm has touted to its clients the prowess of a specific investment strategy, whether deployed by the advisor himself or by a third party, and that strategy underperforms, the value of the firm will decline precipitously.

Remember, a 10% drop in client assets from attrition (or poor investment performance) doesn’t translate into a 10% drop in a firm’s value. The drop could be 20%, or more, given that the fixed costs of a firm remain the same, while the revenue is declining. Further, a firm that is slowly shrinking has a much smaller net present value than a firm that is experiencing some growth.

If your goal is to sell, merge or transfer your business in the next few years, having your portfolios managed in a more mainstream way will ensure both that you have high client retention and that you will receive maximum value when you transact.

Scott Hanson is co-founder of Allworth Financial, formerly Hanson McClain Advisors, a fee-based RIA with approximately $16 billion in AUM.