Attorney Diversification Using Custom Indexes

Many AmLaw 100 firms don't allow their partners to own individual stocks due to conflict of interest concerns.  However, there are other ways to achieve attorney diversification.The obvious solution is for the partners to own diversified baskets of equities such as index funds or ETFs and mutual funds.  However, these are not good options because of the likely large overlapping risk exposures to the partner’s firm and practice group.For instance, if the partner is doing transactional work in the technology sector, an investment in an S&P 500 index fund would be sub-optimal due to the large weighting of technology stocks in the index (currently 26.17 percent).This problem could be worse with actively managed funds which could be even more heavily weighted in technology stocks than the index.Table 1: Technology Sector Weighting[1]

The return of the S&P 500 technology sector weighting to 2000 bubble levels should be a flashing warning light for anyone with exposure to the sector.  Remember, selling high is the goal of investing.  If partners are overly exposed, now is the time to rebalance.

Building a Custom Index for Attorney Diversification

An elegant alternative to unwanted exposures to a sector in an ETF or mutual fund is to build a custom index.A custom index can be created many ways, but the easiest is to use sector and industry ETFs to build an index that omits the sector(s) the partner is most heavily exposed to through her practice.In our example, a custom index could be built that excluded the technology sector.  The allocation that would have gone into technology could then be divided over the remaining sectors.Table 2: Sector Correlations to Technology[2]

The custom index removes the direct exposure to the technology sector but at a low cost.For instance, over the past five years, the custom index had a 97 percent correlation to the S&P 500 and generated a 71.8 percent total return.  While this performance is not as good as the 86.69 percent total return on the S&P 500 over the same time, it was achieved at much less risk to the partner.  Indeed, on a risk-adjusted basis, this is a home run.I am not thinking about risk in volatility terms, but in terms of risk to the partner’s Total Wealth, which is much more critical.  (For a more in-depth look at this phenomenon, see my Company Town Risk® series.)Furthermore, over the past five years, it is likely the partners Total Wealth would have benefited by many multiples in excess of the underperformance in the custom index.This is simply because the partner's compensation will be closely tied to the transactional work she does with technology firms.  Higher stock prices tend to lead to more M&A and other corporate activity.To put it in perspective, if the partner had $5 million in the custom index, the approximate 15 percent underperformance would amount to $750,000 over the five-year period.  If the partner was making $4 million per year, she would have grossed $20 million over the same period.  The $750,000 is 3.75 percent of the $20 million in income.This is a trade that every AmLaw 100 partner should be willing to make, irrespective of their particular sector exposure.  (Also, the technology sector is the extreme case.  Most sectors don’t experience the volatility of technology.)Of course, when the cycle turns and the technology winners of today become shunned, the custom index will really demonstrate its value.  If the technology sector were to experience another 2000-02 type selloff, the custom index could easily outperform by double digits.This would help cushion any reduction in the partner’s transaction work, and income.

Financial Planning for Attorneys

Techniques such as the custom index are critical for attorneys to de-risk their Total Wealth.Bantam takes a risk-first approach to financial planning and develops completely personalized, professionally designed and bound Family Strategy Books to address these and other issues.Please contact Bantam CEO Jack Duval to discuss how we can work with you:  845.605.1007.