WHEN STOCK MARKETS began their three-year downward spiral in 2000, high-net-worth individuals – those with more than $1 million in financial assets – were among the first to move from equities to fixed income. While many pension plan sponsors dithered and finally moved into bonds only when they were already expensive assets, wealthy individuals showed themselves to be more nimble.
Today, the equity bear market appears to have run its course but the equity outlook is uncertain, bonds and credit have suffered a sharp correction, and currency markets may be at an inflexion point as the dollar strengthens and high-yield currencies fall.
With an estimated combined wealth of $30 trillion, high-net-worth private investors are on the move once more and where they are heading might interest institutions. Bonds are out of favour; appetite
for equities remains muted; and alternative asset classes are in demand along with structured products, as wealthy individuals seek to diversify their exposures.
Euromoney asked the world's leading private banks what asset allocation they would now recommend for a fictitious client with $20 million in surplus assets in each of the world's regions.
Having lost substantial amounts of their wealth during the bear market, high-net-worth individuals continue to focus on capital preservation. At the same time, they are focusing on absolute returns. "It's no good telling a client that they've lost 10%, but not to worry as the benchmark lost 15%. High-net-worth investors won't put up with that. They want above-benchmark returns when the market is going up, and absolute returns when it's coming down," says one respondent.
In order to ensure both demands are met, private banks are promoting diversification. "If you look at the end-of-year returns of various indices across different asset classes, you can see how volatile each one is. Last year's winner can be next year's loser [see chart]. It's therefore important to diversify as much as possible," says Paul Reynolds, head of portfolio management at Credit Suisse Private Banking UK. "And I reckon 95% of high-net-worth individuals are not sufficiently diversified in their investments," says Jeremy Marshall, CEO of CSPB UK. "They may think they have a diversified portfolio in terms of asset mix, but they forget to include their company or properties as assets. And some investors believe themselves to be diversified because they are employing three different private banks, but this is not the case, as very often all three banks will follow a very similar investment approach."
This was apparent from the asset allocations recommended by the respondents. Where clients shared similar risk profiles, the allocation to bonds, cash, equities, hedge funds and other alternatives was similar. But within the asset classes, the private banks differentiated themselves by creating products or applying strategies that would ensure absolute returns.
Bonds
High-net-worth individuals have already been reducing their fixed-income allocation because of expectations of higher interest rates. The high correlation with real-estate investments has led some to hold on to property but remove bonds from their portfolio altogether. "Developed world government deficits are high and interest rates are only likely to go one way, so neither government nor corporate debt looks very enticing," says Sandy Cross of Williams de Broë, which recommends a zero allocation to bonds for its UK investor seeking high growth.
For the more conservative investor, bonds remain an essential core element of a portfolio, but private banks are creating products that will enhance returns. SG Private Banking Asia has several structured fixed-income products, using notes issued by itself. "Our first recommendation follows our interest rate forecast – we expect US rates to rise up to a level of 2.5% to 3% over the next two years before stabilizing," says Daniel Truchi, CEO of SG Private Banking Asia Pacific. "The client would invest in floating-rate notes of Libor plus 5% for the first two years to take advantage of the rising interest rates. When rates stabilize at around 3%, the product will implement a fixed-coupon strategy of 7% for the remaining years. In order to achieve such yields, the three-month Libor has to trade in a range of 0% to 7%. This means that the coupon will be accrued daily as long as the three-month Libor trades between that range. Nevertheless, it is reasonably safe as the three-month Libor has not breached that range over the past 10 years. In the case interest rates increase at a slower pace than anticipated, floating-rate notes would underperform medium-term notes. Therefore, we would recommend also investing in a reverse floater offering a fixed rate of 10% the first year and then an arithmetically increased rate minus the three-month Libor (previous coupon + 2% – Libor, for example in the second year the coupon would be 10% + 2% – Libor). Compared to the previous product, the reverse floater is best suited in environments where interest rates remain flat or rise slightly. Combined, these products offer a good way to benefit from higher yields while limiting the risk of exposure to the wrong side of the curve."
Bonds linked to equity indices, currency baskets, commodities and inflation, and those with overlaying put options were also cited by respondents as being included in a portfolio as a hedge.
Equities
Equities are back in favour with high-net-worth investors as global economic growth revives. Yet there remains a sense of caution among the private banks. In a conservative portfolio, allocations to equities from the respondents did not exceed 25%. US and European equity valuations leave little room for price appreciation, and allocations in these geographical areas focus on defensive stocks with high dividend yields. "High-growth stocks are still in a bear market. Valuations are very high and investor appetite in this segment is limited," says Dresdner's head of investment strategy, Herbert Berger.
More than 75% of the respondents favoured Asian and Japanese equities despite recent volatility. "Asia's markets are moving from a liquidity-driven phase to an earnings-led recovery. For 2004, we expect earnings growth of more than 20% on a forward PE ratio of 19. There is plenty of liquidity in the banking system, with Asia's local investors sitting on $2.1 trillion of bank deposits. And the Asian corporate balance sheet has been cleaned up, with net debt to equity at 38.5%, the lowest leverage rate over 20 years," believes ING Private Banking Asia's Soon Gek Chew. "The long-term sustainable economic growth of Asia will be significantly above that in the developed world as a result of continuing labour supply growth and productivity improvements. Demographics are on her side. A lot of worst-case election outcomes for Taiwan, Malaysia, the Philippines and Indonesia in 2004 appear to be discounted by markets. As long as higher rates in the US are in response to cyclical growth and not high inflation, Asia should hold its ground."