Understanding the Discretionary Model of Wealth Management

A Chinese proverb tells the story of a sage who rendered significant service to the empire and was asked by the emperor what he would like as a reward. The sage replied, "All I ask is one grain of rice today, two grains tomorrow, and four the following day, and so on for the rest of my poor lifetime."

“Ah”, said the emperor, “surely you must ask for more than that!”. But the sage was firm in the modesty and the emperor agreed to the bargain. The emperor failed to realise that there wasn't enough rice in all of China to fulfil his duty to the sage until a few months later. Knowing that he had been evilly tricked, the emperor had the sage executed, bringing to a brutal but effective end this episode in the thrill of compound interest.

And this is precisely the point: Nothing compounds forever, or even for very long. There are number of reasons why the magic of compound interest rarely plays out in the lives of investors – social and economic disruptions, hubris, lack of time, lack of knowledge, absence of quality advice, and so on.

But the one reason that silently derails the process of compounding in lives of most affluent investors is poor decision making & poor execution on an ongoing basis.

Poor decision making & execution manifests in two ways:

First is the mis-placed belief of most investors that wealth is driven primarily by fund/security selection. Wealth is not determined by investment performance alone, but by investor behaviour. What your funds/securities do versus other, similar funds is relatively unimportant. The important thing is what investors do and don't do. There are steps thoughtful investors can take to minimize the likelihood of irrational actions and to blunt its consequences – but that is a subject for another article.

Second reason is the accumulation of opportunity costs due to delayed decision making. "Opportunity costs" are the price changes that take place between the time an investment concept is conceived and the time it is implemented.

Let me explain, the Wealth Management industry is pre-dominantly involved in managing client portfolios on a nondiscretionary basis. Under the nondiscretionary engagement, the portfolio manager makes recommendations, and the investor accepts or rejects them.

In this engagement, the advisor typically works on a quarterly cycle of review and recommendations. In most instances, several days can pass between the formulation, sharing, discussion and final approval of investment ideas. If a family depends on an investment committee, this can result in additional delays. This lag leads to opportunity costs, that accumulate & compound over time – resulting in serious performance gap.

Practical example - in the month of March 2020, for a period of only 3 days, few high-quality bonds (AAA rated) were available at attractive yields between 8.0%-9.5% for a 3-year investment horizon - approximately ~ 1.5% - 2% above their usual rate then.

In a nondiscretionary engagement, the advisor typically works on a consultative model & if the advisor was acting diligently, following could have panned out:

On Day 1 - the advisor formulates an investment idea - say the mis-priced high-quality bond in this case.

On Day 1(if the advisor is disciplined) - this idea is converted into a written recommendation for the client.

On Day 3 - The client (if not traveling abroad), eventually gets around to looking at the recommendations.

On Day 5 - A meeting or conference call is setup to discuss the recommendation

On Day 7 or 10 - following the meeting the client takes the matter under advisement.

Eventually, the client approves, modifies, or disapproves the recommendations.

The advisor then implements the recommendations as made or as modified. By the time this whole cycle would’ve ended, the limited period opportunity to lock in munificent rates had been lost and the advice had become stale. Even the best of wealth management companies can’t help you if the advice to execution time is so long.

No, this isn’t the norm, but it's not an outlier outcome, either. I've had a client who waited nearly a year to act on moving his funds from savings account to a simple liquid fund because he wanted to parse through the fact sheet of one of the largest liquid funds!

Investors may not realize it but these lag leads to opportunity costs, that accumulate & compound over time – resulting in serious performance gap.

Fortunately, a new model of seeking guidance has emerged over the past 20 years that addresses most of the decision-making problems that a non-discretionary model exposes a client to. Discretionary investment services or OCIO (outsourced chief investment officer) are the terms used to describe this model.

Under the Discretionary model, an expert team of designated portfolio managers can make changes in a client’s portfolio on the client’s behalf without seeking the client’s consent for every trade (strictly & only within limits & guidelines specified under the mutually agreed upon & signed portfolio guidelines).

The portfolio management team uses the same set of tools that are used under the traditional non-discretionary model – careful preparation of a formal plan that incorporates multiple asset classes, skills in asset allocation, manager selection & disciplined rebalancing – but these skills are exercised on a Discretionary basis.

In the developed world, in past 15 years, the demand for discretionary mandates has outpaced the enquiries for non-discretionary mandates, especially in the new normal of low returns and higher volatility (more on the new normal in a separate article).

If you were to outsource whole/parts of your portfolio to a competent discretionary investment services set-up, you are likely to enjoy following competitive advantages:

Reduced opportunity costs:

In the case of afore-mentioned, mis-priced bond opportunity, under discretionary model, the portfolio manager would’ve ideated on day zero & most likely executed on day 2. Simple and clinical. This one benefit will probably prove to be the deciding factor in adopting the discretionary approach for the majority of investors who are serious about compounding their wealth and who are outcome focused.

Sets you free to focus on primary mission or interests:

Allowing investors to focus on their core interests and or other business, professional or philanthropic activities, and allowing institutions to focus on their core missions, is one of the advantages of the discretionary/outsourced CIO model.

Enhanced oversight:

Discretionary/ OCIO model ensures that professionals are managing the portfolios constantly, not once a quarter when the family or investment committee meets.

Intellectual capital:

In a non-discretionary engagement, the advisers frequently simplify their suggestions moving forward, either intentionally or unconsciously, to feed into the client's confirmation bias when the investor expresses discomfort with strategies, asset classes, or managers. In a fully discretionary engagement, the advisory firm's whole think tank and delivery chain (Research-Product-Fund Team-Domain Experts-Relationship Manager) combine efforts to manage the client's portfolio, which benefits from the full intellectual capital of the advisory firm.

Do a sincere self-evaluation of your investment temperament, the time you have available to participate in a well-defined investment process, and your skills or the experience of your internal investment team (if you have a family office). Please think about giving up control of some or all your valuable portfolio if there are any gaps in time, temperament, or competence and consider hiring a capable OCIO (Discretionary service provider).

Make sure you get one of the top investment advisors in India & ensure they are unconflicted and is exclusively paid by you.

Finally – an unsolicited advice on choosing an advisor - do not care what they know, until you believe that they care.

Happy compounding!