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Security Crisis

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This is a time of uncertainty. Given the events of the past several months, it’s unclear what will happen next–socially, politically, or economically. One thing that is perfectly clear, however, is the need for security: for the individual, for the nation, and for the portfolio.

To most advisors, this isn’t new: we’ve always been in the security business. But over the past several months, something has changed. As markets slide in the wake of political events and gloomy economic forecasts, clients have changed the way they think about their portfolios. No longer are investors thinking about performance when they talk about their investments: They’re talking about protection. Far from a bad thing, this “security crisis” presents an extraordinary opportunity for advisors to demonstrate value to their clients. By positioning yourself as a security expert, you can protect client wealth and build your business during uncertain times.

Talking about Security

Certainly, security means different things to different people. But in the context of our roles as protectors of client wealth, security means protection from forces that threaten the capital and, by extension, the quality of life of our clients. Right now, the most obvious threat to capital is the market itself: without effective defensive strategies in place, volatility can decimate a portfolio, and leave clients without the means to pursue life goals. But capital can be threatened by any number of forces: the taxman, creditors, inflation, and so forth. This means that whenever we discuss financial security with our clients, we need to talk broadly, and speak not only about investment strategies, but also tax planning, estate planning, and other issues.

This is particularly true when dealing with high-net-worth individuals (HNWIs). Simply put, the large portfolios and complicated financial arrangements of the wealthy demand a multi-faceted approach to financial security. This means we have to be more skilled, knowledgeable, and aware of security issues. What follows is a brief overview of what I consider to be the three things every HNWI should be doing right now to protect capital. Cover these three points and you’ll be well on your way to securing the long-term financial security of your clients.

Strategy #1: Alternative investments

I’ve seen a lot written about alternative investments lately, and it’s easy to see why. While the S&P 500 posted an 8.2% loss in September, for instance, the Tremont hedge fund index largely held its own, posting a drop of only 0.8%. Given the current investment climate, that kind of protection is something every HNWI needs to take seriously.

The economic expansion of the late 1990s resulted in an explosion of alternative investments. The 2001 edition of the Merrill Lynch/Cap Gemini World Wealth Report estimates that there was approximately $261 billion in hedge funds in 1996; as of 2000, that amount had grown to over $400 billion. Private equity has grown even faster: there was $45 billion invested in private equity funds in 1996; as of 2000, there was $163 billion. This growth means there is now a specialized hedge or private equity fund for almost every situation imaginable.

But while there are now more choices than ever, not all of them offer security in the true sense of the word. When it comes to security, alternative investing comes down to one thing: correlation with standard investment classes. Ideally, an alternative investment will offer non-correlated or negatively-correlated performance (two different things) when compared to a traditional asset benchmark. Such an investment can anchor other sections of the portfolio in volatile times, and help your clients achieve higher returns at a lower level of risk. Sounds good in theory, but not every alternative investment offers such performance. Make sure to consider historical returns of any alternative investment alongside market benchmark returns before you make a recommendation (see chart on right).

Strategy #2: The value of diversification

Recent events have demonstrated how even the largest, most efficient market in the world can succumb to unforeseen political and economic events. They have also demonstrated why HNWI portfolios need to be fully diversified. Of course, diversification is hardly a new investment strategy, but while the U.S. market was booming, it was an easy strategy for HNWIs to ignore. Now that the market has come back to earth, it’s a perfect time to remind clients how critical diversification really is.

At the moment, some may consider investing outside North America to be unpatriotic. But spreading a portfolio among a variety of markets, assets, and management styles just makes sense. There are numerous statistics to support my argument; one I’ve found particularly convincing comes from Brandes Investment Partners. It tracks the relative performance of six representative equity classes–large-cap growth, large-cap value, mid-cap, small-cap, the S&P 500, and international equities–from 1988 to 2000. The research shows the kind of back-and-forth fluctuation that happens among asset classes from one year to the next. One example is the international equities category, as measured by the MSCI EAFE index, which came in first in 1988, last from 1989-1992, first from 1993-1994, and last from 1995 to 1997. Show this to a HNWI client, and your client will immediately understand that a diversified portfolio is a secure portfolio.

With some HNWIs, the issue of diversification is more complicated. Business owners and corporate executives often became wealthy by way of concentrated equity positions (all but one of the top ten names on the annual Forbes ranking of the world’s wealthiest people got there by hanging on to large positions in their respective businesses). In times of volatility, however, these positions can pose a grave threat to financial security. While moving out of such a position is never easy, now is definitely the time to discuss specialized hedging and/or diversification plans with your HNWI clients. A customized divestiture or prepaid forward contract is an excellent strategy for entrepreneurs looking to extract equity from their business. For those with large stock positions (as a result of an options exercise, for instance), a customized stock collar might be a good idea.

Strategy #3: Estate protection

When discussing security with HNWI clients, we need to look beyond the portfolio. To that end, one crucial element of financial security that advisors should discuss with their HNWI clients is estate planning. By protecting not only a client’s portfolio, but also the client’s family and personal legacy, advisors can secure wealth and preserve it for multiple generations.

Most HNWIs require sophisticated estate planning. Given the complexity of such plans, you’ll want as much time as possible to discuss options and implement appropriate strategies. Which is why you’ll want to review specialized estate structures and relevant tax regulations with your clients now. If your HNW client is a business owner, you’ll want to discuss the possibility of an estate freeze, or establishing a holding company to minimize estate taxes. Most HNWIs consider charitable giving an important estate planning goal. There are many options for charitable giving–endowments, charitable lead trusts, private foundations–but by discussing a charitable giving structure now you’ll ensure your clients’ intentions are as secure as any other part of their portfolio.

For business owners and corporate executives, security also means protecting assets from legal challenge. It’s a fact of life: business trouble and shareholder lawsuits multiply in times of economic hardship. A good estate plan can mitigate such risks and keep wealth secure. Structured properly, a trust can put personal assets beyond the reach of creditors. A holding company can often be an equally viable alternative. For corporate executives, specialized insurance can offset the risk of a shareholder lawsuit. Even if you’re not an expert in these areas, demonstrating your consideration of such issues demonstrates a security-first attitude that’s sure to add value to client relationships.

Chances are your HNWI clients are worried about security, and rightfully so. But as the saying goes, behind every cloud is a silver lining. Demonstrate that you care about your clients’ financial security, and you can secure your own business in these uncertain times.


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