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Functional Asset Allocation Overview - Based on the Article by Bert Whitehead

  
Edited by Michael Garber, CFP®, CRTP August 2017
Based on the Article “Functional Asset Allocation: A Model for Real People,” by Bert Whitehead, MBA, JD and founder of the Alliance of Comprehensive Planners

Introduction

In finance, the process of Asset Allocation has developed to optimize investment return from a portfolio, given an expected level of volatility. This approach developed after studies of the historical performance of a variety of asset classes used in many types of investment portfolios.  The traditional approach to asset allocation is based on the needs of institutional portfolios, or those of the very wealthy. The output of traditional asset allocation is a percentage breakdown of the amount of the portfolio to be invested in each recommended asset class.

An alternate approach, known as Functional Asset Allocation, was developed by Bert Whitehead and has been adopted by the Alliance of Comprehensive Planners. FAA challenges the approaches of traditional Asset Allocation, including risk tolerance tests, inflation adjustments, and exogenous factors, such as global political or economic conditions. FAA instead proposes to serve the needs of “real people,” whose lives operate differently than pension funds or institutions. In part, it is based on ancient principles outlined in the Talmud, but it also conforms to the ideas of Modern Portfolio Theory.

There are several factors which are approached differently when using FAA. Generally, fund managers do not need to take these factors into account when designing an asset allocation:

  • Inclusion of personal and investment real estate, including leverage of these assets.
  • Tax considerations of individuals and families, including income, gift and inheritance taxes.
  • Liquidity needs at various stages of life, referred to as the financial life cycle.

In each of these areas, the individual investors face different conditions than institutions. 

As investment transactions, research, and even asset allocation become increasingly commoditized, sophisticated investors require a more comprehensive financial planning approach than mere asset management. Personal financial advisors can benefit by using an asset allocation model which demonstrably enables them to add value for their client by expanding the scope of their practice to include real estate considerations and tax strategies. 

Personal financial advisors who have embraced the concept of Functional Asset Allocation find it valuable to become Enrolled Agents (EA’s) to be able to show the client how to benefit by having proper “Asset Location,” the positioning of particular asset classes in tax-advantaged vehicles.

Functional Asset Allocation Principles

Functional Asset Allocation takes a different overall approach, centered on individuals and families. First, we track the annual growth of a client’s overall net worth, rather than returns from the investment portfolio. Second, each asset category has specific functions. Third, advisors can add value by maintaining proper asset allocation based on endogenous factors, and by supporting clients with the discipline to maintain equity positions during down cycles and continue regular periodic investments through maintaining proper liquidity.

Functional Asset Allocation focuses on the annual growth of a client’s “total marketable net worth”, rather than quarterly investment portfolio returns. “Total marketable net worth” is classified into three functional asset categories: interest earning (bonds and cash); real estate (including personal residence); and equities. Interestingly, this asset allocation system was originally espoused by the Talmud’s admonition to “invest a third in land, a third in business, and a third in reserves.” Utilizing a functional approach approximates the equal one-third allocation promulgated by the Talmud.

 

Asset Categories

Each asset category has specific, distinct functions in a portfolio. When properly balanced, a functional portfolio should protect a client from deflation as well as inflation, and yet enable the portfolio to achieve higher market returns from equities. 

Interest earning investments functionally provide for capital preservation. For real people, capital preservation entails providing uninterrupted cash flow, adequate emergency reserves to preclude the necessity to sell long term investments at a disadvantage, and most importantly, long-term protection from deflation.

Real estate as an asset category provides protection from inflation since real estate is the most inflation-sensitive asset. Properly leveraging realty (particularly a primary personal residence) with long-term fixed mortgages is a key tax-advantaged strategy to protect a client against inflation. Leveraging in turn requires adequate liquidity to buttress the mortgage risk, and impacts the allocation within the interest earning category.

Equities is the asset category that provides long-term growth. The function is to enable the investor to participate in the larger U.S. and world economy as an equity participant. Equities provide market returns from a balanced portfolio, which will enhance the return on the client’s total marketable assets over time. The long-term advantage is easily obscured by the short-term volatility, and the studies of behavioral finance demonstrate that an individual’s perception of their own risk tolerance varies in direct correlation to market trends.

Utilizing Functional Asset Allocation (FAA) requires an approach which addresses risk and lifecycle stages from a different perspective than traditionally used. Portfolio changes using FAA are triggered by endogenous rather than exogenous occurrences. Spending projections are not adjusted long-term for inflation, reflecting the observed spending patterns of “real people” after retirement. Instead, spending plans are reviewed and updated annually in light of actual income and expense results.

Endogenous Approach to Risk Exposure

Evaluating a client’s “risk tolerance” is a concept widely accepted to be important in most asset allocation models. This is a reactive approach, requiring a financial advisor to tailor a portfolio to a client’s presumed comfort level for risk. In contrast, FAA requires a financial advisor to be more proactive: it is the advisor’s responsibility to advise the client as to how much risk exposure is appropriate. This calls for a much more in-depth understanding of a client’s finances, and encompasses three key areas: lifecycle stage, evaluation of risk taken outside the portfolio, and risk needed to achieve goals.

 

Functional Asset Allocation Adds Value to the Client Relationship

Functional Asset Allocation is emerging as a productive model for financial advisors to use when advising real people. Asset categories include real estate as well as interest earning and equities. Real estate includes asset classes which encompass the personal residence as well as other physical assets. These assets are the keystone for utilizing leverage and gaining tax efficiency in the total financial situation. Allocation strategies are implemented with tax-driven tactics which stress “asset location”, i.e. the functionally appropriate vehicle relative to each asset class (e.g. using qualified vs. non-qualified funds). This approach requires a sophisticated understanding of personal income taxes as well as a ‘quarterback’s view’ of the client’s total financial situation. 

FAA principles enable an advisor to add measurable value to the client relationship on a personalized, professional basis, without requiring demonstrable superior investment results.

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