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Great Expectations

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Being a millionaire isn’t what it used to be. A once-mythic club with few members, about one in 50 Americans is now worth seven figures. In fact, there are so many millionaires in the U.S. that the slightly derogatory term “mass affluent” has been attached to them. Moreover, many of these folks are too ensconced in debt to be good candidates for asset management.

Indeed, the real target for wealth managers is the “ultra-affluent”–those with a liquid net worth north of $5 million. This segment is growing even faster than their mass-affluent counterparts. In fact, the number of households worth $5 million or more is expected to grow at least 8% per year for the next decade, even if the current recession keeps chugging along.

There are currently about 500,000 penta-millionaires in the U.S., and they should be on the radar screen of every enterprising investment advisor. After all, advisors who concentrate on the ultra-affluent have some of the highest profit margins in the industry. Further, the super-wealthy aren’t any more fee-sensitive than less affluent clientele, and they are often willing to give referrals.

The client pictured at left, Mike Rose, embodies many of the time-honored characteristics of the affluent. He has ample assets and a lifestyle that reflects his years of accomplishment. Along with the attributes one would expect from such a super-successful client, he also has a few characteristics that may be a bit of a surprise, including an aversion to traditional asset classes. According to Rose, “Equities are a much riskier investment now than at any time I’ve followed them.” Building a portfolio around an opinion like that is not an easy task.

In fact, when it comes to developing a practice for the super-wealthy, few things are easy. Ultra-affluent investors place investment performance much higher on their list of priorities than other folks, which requires advisors to spend more time on portfolio construction and security selection. The wealthy also demand customized solutions to their financial objectives; off-the-shelf products just don’t scratch their itch. They also expect “cross-platform” advice on such diverse subjects as estate planning, taxation, and trust formation, which requires a level of expertise that demands a lot from advisors. The emphasis on planning is the driving force behind the movement of ultra-wealthy assets from brokerage firms to advisors, according to a recent study performed by the Spectrem Group, a Chicago-based research firm.

It’s no wonder, then, that in the world of ultra-affluent advisory work, many are called yet few are chosen. Although building a stable of penta-millionaire clients is a difficult task, this growing niche offers tremendous opportunity for those willing to invest the time and effort necessary for success.

Markedly Different

The difference between the ultra-affluent investors and their mass-affluent counterparts hardly stops at size. Higher-net-worth individuals, for example, tend to be more conservative, and hold more of their portfolios in fixed-income securities and hedge funds than do other investors. The ultra-affluent also tend to have more grounded expectations for asset class returns. As a result, they seem more willing to commit to an expensive, actively managed product with a great investment team than an inexpensive index fund.

The ultra-affluent also tend to be a relatively hands-on group, usually spending more time consulting with their financial advisors, meeting with accountants, and generally managing their wealth than others do. But this is not necessarily because they have more money than most folks. As Thomas Stanley pointed out in his book The Millionaire Next Door, it’s the other way around; the wealthy wind up with more money because they plan more.

According to most ultra-affluent investors, the bottom line in creating wealth is not simply about making more when times are good. It also entails protecting assets when times get tough.

Take our client Mike Rose, for example, who rose in prominence as the chairman and CEO of Holiday Inn Corporation, the best-performing large-cap growth stock in the 1980s. In the late 1980s, the company experienced two significant liquidity events. “According to the financial planners I talked to at the time, the game was all about creating long-term capital gains, which meant long-term investments in equities,” Rose says now. “The difference in taxation between long-term and short-term gains was so significant that the idea seemed to have some merit. But after the late ’90s bear market, it became obvious that I took a lot of risk and gave up a lot of wealth in an effort to structure my holdings in the most tax efficient manner.” The lesson Rose learned–that taxes can’t be the tail that wags the investment dog–”convinced me that going for a more certain but smaller return was the best way to manage my portfolio.”

His solution, like many other ultra-high-net-worth investors, revolved around hedge funds. “I was fortunate in that my first significant investment in alternatives was successful, which encouraged me to continue along that path,” Rose says. “In my mind, hedge funds do a great job of managing risk while allowing for most of the upside of an unhedged equity investment.”

At first glance, the keep-what-one-has mentality of the wealthy may not seem much different than other investors. But the way many of them seek to achieve these goals lies in stark contrast to the traditional asset allocation methodologies that have ruled the investment industry for decades.

If this seems a bit revolutionary, it is. But one must consider that even the most conservative and hidebound investors are now rethinking previous assumptions. Consider, for instance, defined benefit pension plans. While most clients’ investing horizons are decades away, pension plans not only have to invest for the future, but must also be liquid enough to meet the needs of current retirees. How have pension funds changed their investing strategies? According to many industry experts, neither objective can be met with a mix of traditional assets.

Recipe for Disaster?

Defined benefit (DB) plans, which are utilized by the bulk of companies in the S&P 500 index, are a type of plan in which a retired employee receives a specific amount based on salary and years of service, and in which the employer bears the investment risk. The objective of plan administrators is to invest contributions in such a way that the plan’s future liabilities can be met with future assets.

In 1980, Fischer Black, the developer of the Black-Scholes option pricing model, wrote what many consider to be the definitive study on pension fund management. In his view, shifting from equities to bonds in a DB plan makes benefits more secure, even though stocks may be expected to have a higher return. Having the assets in stock will reduce the expected contributions by the firm, but can only make the pension beneficiaries less secure, since it reduces the present value of any defined set of benefits. Just as an increase in the risk of a firm’s assets that doesn’t change the firm’s value will make the bondholders less secure, so an increase in the risk of the pension fund assets that doesn’t change the fund’s value will make the beneficiaries less secure. And since investing pension fund assets in bonds makes the beneficiaries more secure than investing in stocks, it should make the trustees more secure as well.

Fixed-income securities also do a pretty good job of matching the liability stream faced by DB plans. But nearly all plans have to deal with liability “noise,” which mostly comes from such hard-to-predict variables as salary increases. The only way to adjust for those hard-to-predict expenses is to add an equity component to the mix. And as the equity markets continued climbing with hardly a pause in the late 1990s, pension administrators began slowly ratcheting up their stock exposure.

It is easy to see why equities were so tempting during the last bull market. As valuations increased, pensions became overfunded, which resulted in a decrease in required pension contributions from corporations, which in turn helped the company’s stock prices rise. Eventually, the bear market that began in 1999 ended this virtuous cycle. Plagued by years of stock market losses and historically low interest rates, U.S. pension plans are now facing a funding crisis. In just the last three years, the defined benefit plans of the companies in the S&P 500 index went from 30% overfunded to 20% underfunded.

It is foolish to blame the current pension plan mess on administrators; after all, everyone knows how difficult it is to predict market returns. But it seems hard to believe that administrators were acting within their mandate to allow such an egregious mismatch between plan assets and liabilities. It also seems as if the plans were slow to adjust to changing market conditions, which can be blamed mostly on slow-moving asset allocation committees and other bureaucratic entanglements.

The ultra-wealthy have neither of these issues. They can change their asset allocation at will, with the only slowdown being the speed with which their advisors can act. Does that make them better investors? Perhaps so. According to the World Wealth Report, an annual publication by Merrill Lynch and Cap Gemini Ernst & Young, the financial assets of the most affluent investors appreciated 3.6% in 2002–a year that saw the domestic stock market lose nearly one-quarter of its value.

In essence, the mega-wealthy have examined the time-honored, traditional stock/bond portfolio construction process, and have found it inferior to a whole new way of looking at investing that emphasizes a targeted return approach. A different method, one that emphasizes targeted returns within given risk parameters, comes much closer to meeting the needs of the ultra-affluent investor.

Common Ingredients

Wealthy investors have traditionally kept the bulk of their portfolios in fixed income, which includes Treasuries, municipals, and corporate bonds. Such investments have produced high single-digit gains with minimal volatility over the last decade. Further, the security provided by bonds becomes particularly significant in times of financial crises, when investors embark on a flight to quality. But more important, wealthy investors (similar to defined benefit plan administrators) prefer fixed income because it does a good job of matching assets with liabilities. Equity investments represent a meaningful yet small position in most ultra-wealthy portfolios.

There has been a dramatic sea change in this allocation strategy over the past three years. A combination of bearish market conditions, high valuations, and muted economic activity has severely reduced expectations for traditional investments. Most of the ill feeling toward stocks is based on the equity risk premium (ERP), the measure of prospective return differences between stocks and bonds. For example, an investor who believes that equities will return 5% more than fixed-income securities would be willing to pay that premium to own stocks.

The ERP has been a consistently positive number for most of the last century. But during that period, the average dividend yield was over 4%, over twice the current yield of the S&P 500 index. Further, earnings growth, a metric that consistently lags long-run real GDP growth rates, is expected to increase more slowly than the historical 1.5% rate going forward. As a result, a gaggle of market gurus, including Warren Buffett, Peter Bernstein, and Robert Arnott, expect stocks to return much less than the 7% annualized return they have delivered since 1800. Several, in fact, expect the equity risk premium to be zero. In that scenario, stock and bond returns would be about the same.

If stock and bond returns are the same or much closer than they have been historically, the decision on how much to weight each asset becomes moot. What does matter, though, is alpha generation. In a world where a traditional 60/40 stock-bond mix will likely return less than its historical norms, even a small amount of value-added can reap enormous benefits. The issue for taxable accounts is where to search for alpha. And no investment is a purer source of alpha than hedge funds.

Over the last five years, hedge funds overall have pulled off the trick of producing equity-like returns with bond-like volatility. The ultra-wealthy were the first investors in these vehicles, and their commitment to these funds has steadily increased. Although hedge fund returns are likely to be muted alongside traditional investments, the two will likely not move in lockstep. In fact, a number of different alternative investment strategies are not correlated with the stock and bond markets. As a result, attempting to produce 2% to 3% of additional return from hedge funds is a reasonable objective.

Although hedge funds are among the most popular diversification tools, there are alternatives. Many wealthy investors also utilize real estate, either directly or in the form of REITs, commodity funds, and Treasury Inflation Indexed Securities, or TIPs. The latter investment has enjoyed enormous popularity, especially among investors who are annuitizing their assets. However, TIPs are aggressively taxed, and are typically only held in qualified accounts.

And what about equities? Stocks are still part of most wealthy investors’ portfolios, but many of them end up purchasing low-cost exchange-traded funds instead of actively managed mutual funds, preferring to get active management exposure from their alternative investments.

The Planning Part

Of course, there’s a lot more to financial planning than simply investing. Even the most well-heeled clients need advice on matching their incomes with their outflows. In the case of the ultra-wealthy, it’s important to help clients separate “use assets” such as homes, cars, and other non-revenue-generating assets, from “investment assets.” The next step is to put annual spending into categories. Since most individuals of significant wealth have a bookkeeper or accountant who helps with their bill-paying (see sidebar at right), this is not an onerous task; at the same time, don’t underestimate the amount of manhours necessary to produce a useful model.

Coming up with a targeted after-tax return expectation is the next step. At this juncture, both clients and advisors should select their target carefully. If hedge funds are not a part of the portfolio, any assumption over 6% is aggressive. A portfolio that includes carefully selected alternative investments may be able to produce returns in the 9% to 10% range.

In most cases, it is unrealistic to assume that an ultra-affluent investor will custody assets in one location. Most use multiple custodians simply because they don’t want all of their money in one place. Past relationships are another factor. For example, one of our wealthiest investors uses a broker for part of his assets simply because the broker helped him gain membership in the prestigious Augusta Golf Club, site of The Masters golf tournament. In any case, aggregation of client assets into one statement is usually a requirement for the ultra-wealthy. Software programs like Centerpiece and Advent offer electronic linking to a number of platforms, including Goldman-Sachs and Merrill Lynch, although a modest annual fee is required. Hedge fund positions, however, must be entered manually.

Although burdensome, account aggregation should be considered a value-added service. In our practice, wealthy prospects often ask how much is required to commit to our firm in order to get account aggregation. Although there are Web-based aggregation offerings, our firm has yet to find the right fit.

Another important service is bill paying, which for some investors is more important than customized reporting services. In either case, it is often true that ancillary services can make the difference in getting new clients.

Indeed, managing the wealth of successful families, like football, is a game of inches. Offering a slew of customized services while trying to keep costs to a reasonable level often makes the difference between success and failure in the high-end business. But if one is able to achieve critical mass, the rewards from catering to the ultra-wealthy can be significant.