Better portfolio construction starts where standardization ends 

Personalization is a familiar promise in wealth management, yet many advisors still place a large share of their clients in broadly similar portfolios. Technology is weakening the main reason that has been true. Portfolios can now be tailored at scale, which means the old choice between customization and efficiency is less of a choice than it used to be.

“Clients may have similar investment objectives, but they don’t necessarily have the same tax circumstances, legacy holdings, liquidity needs or preferences,” says Ken Lassner, Senior Product Strategist, Direct Indexing at Northern Trust Asset Management. “Good portfolio construction increasingly means starting with the client rather than simply placing the client into a standardized product.”

The industry has long been adept at matching investors with products, but matching a portfolio to the circumstances of the person who owns it is a more involved exercise. Taxes can complicate an otherwise sensible investment decision, while existing holdings may make a conventional asset allocation expensive to implement.

As investment products become more widely available and harder to differentiate, greater attention is also being paid to the decisions that determine how those products are used.

A good return can still be a costly one

Investors are accustomed to judging portfolios by their returns, although the performance reported on an investment statement rarely tells the whole financial story. For clients with substantial taxable assets, the gains realized along the way can make a considerable difference to what they ultimately keep.

Lassner believes this deserves greater attention during portfolio construction, particularly when investors arrive with existing holdings that have accumulated substantial unrealized gains.

“In a taxable portfolio, the objective shouldn’t simply be maximizing pre-tax return or minimizing tracking error,” he says. “The more relevant question is how efficiently we can pursue the client’s investment objective after taxes.”

Two clients might hold exactly the same securities, yet the economics of selling those investments could be entirely different. One may have purchased a stock decades earlier and accumulated considerable unrealized gains. Another may have acquired it recently, leaving little taxable appreciation to contend with.

That points to bringing tax into the process earlier, rather than treating it as something to deal with once the investment decisions are made. Lassner leans on a common saying to make the case: “it is not what you make but what you keep after taxes that is most important.”

“Taxes aren’t simply a reporting consequence of investment decisions. They’re one of the constraints portfolio managers should consider when deciding which securities to sell, which gains to realize, where to harvest losses and how quickly to transition a portfolio,” he says. “Incorporating that information upfront lets an advisor evaluate investment risk and tax cost together rather than trying to repair the tax consequences after the fact.”

Diversifying around a concentrated position

A client with concentrated stock doesn’t necessarily want to sell it all tomorrow, so the advisor’s first task is to improve the portfolio without forcing a clean break. Lassner says that starts with a change in how diversification is framed.

“I think the key is to stop treating diversification as an all-or-nothing event,” he says. “An advisor can build a diversified portfolio around the concentrated position, limit overlapping exposures and establish a disciplined plan for reducing the position over time based on the client’s tax budget and risk tolerance. That can turn diversification from a potentially disruptive one-time transaction into a controlled, multi-year transition.”

Concentrated stock is one example of a situation that doesn’t fit an off-the-shelf portfolio. Charitable and estate planning objectives are another.

“In those situations, customization allows the investment portfolio to become part of the financial-planning solution rather than something managed separately from it,” Lassner says.

Consider an investor planning to donate appreciated securities. Selling the shares prematurely could mean realizing gains that might otherwise have been avoided through a qualifying direct charitable donation. Preserving the position until the gift is made may therefore be more appropriate than disposing of it as part of a routine rebalancing exercise.

The product is only part of the advice

Personalization has its own potential excesses. The ability to customize nearly every element of a portfolio does not mean doing so will necessarily improve the result.

A portfolio assembled around too many individual requirements could become difficult to manage, with little assurance that the additional complexity produces a corresponding benefit.

Lassner favours drawing a firm line between the circumstances that warrant individual treatment and the investment disciplines that should remain consistent across clients.

The industry has invested heavily in systems and processes that make portfolio management more consistent. Abandoning those efficiencies in pursuit of customization would be a peculiar way to demonstrate its value.

The more promising development is technology that allows individual accounts to reflect different requirements while retaining a common investment methodology.

“I think the opportunity increasingly lies in construction rather than product selection,” Lassner says. “The differentiated advisor understands how the client’s investments, taxes, concentrated wealth, charitable and estate intentions, liquidity needs and long-term financial plan fit together, and then coordinates those pieces into a cohesive strategy.”

Rather than continually reassessing individual holdings or rebuilding portfolios to accommodate each client’s circumstances, advisors can apply a consistent investment strategy while allowing for the differences that matter to each investor.

That gives them more room to be proactive with clients, anticipate changes in their financial needs and concentrate their investment research on identifying the most compelling opportunities. Personalization need not require an entirely new investment approach for every account. Done well, it allows advisors to bring their best investment thinking to more clients without losing sight of what makes each client’s financial circumstances different.