Where the rich invest

AFR, Smart Money, February 2012

If the world is going to hell in a handcart – and one of the problems of this market is that it could equally be going in the other direction – then where should you have your money? Should we all be in cash, waiting for certainty to return to the world so we can invest again? Or by doing so are we going to miss the start of a bull market and so lose out? If Greece falls out of the euro, what does that mean for all our other investments? And, with the world uncertain, is home best?

There are no clear answers to these questions – nobody is right all the time, and over the last few years an awful lot of very smart people have been wrong quite a lot of the time – but it’s always instructive to see what the rich are doing at a time like this. Private banking clients have access to the best available information; these banks have dedicated teams looking at suitable asset allocation and guiding them on the investment themes that will shape the year ahead.

All of them say it’s going to be a big year, and a tricky one to navigate.

Christian Nolting, head of discretionary portfolio management and strategy for Asia Pacific at Deutsche Private Wealth Management, feels that things have to change in the world in 2012. There can be no more kicking the can down the road, especially in Europe, and that one way or another pivotal things have to happen, creating volatility. “The traditional reaction in a situation of high volatility is almost always to fly to quality and then do nothing,” he says. “That is, avoid risky assets and go instead for cash, sovereign bonds, real estate and precious metals. But what is clear to us is that this time is different. Because of the nature of this crisis, none of these options can guarantee wealth preservation.”

Why? Cash leaves you vulnerable to currency movements (though this isn’t the case if you stay domestic); real estate depends on the availability of mortgages, which is far from sure in much of the world; and precious metals like gold don’t tend to do well when inflation risk is receding, as it is in Asia and Europe. So Deutsche is telling its clients to look at risky assets, even if uncertainty in Europe might make it seem counterintuitive. “Risky assets can offer opportunities in 2012,” its annual outlook for clients says. “Global growth in 2012 should still be close to 3%, which is substantial. We strongly believe that there are ways to leverage this global growth through smart asset selection.”

An example of this is large companies with good governance, plugged into global growth. Valuations in much of the world are pretty low – around 12 times price/earnings in the US, below 10 in Europe – and provided you pick companies that you know will survive, there seems to be long term value. “Market sentiment is very negative at the moment [this was written before the modest rally at the start of the year] but periods of negative sentiment have in the past often been very good entry points into risky assets. The perfect time for entering into such investments is when one is comfortable with them from a rational perspective, but must first overcome an emotional reluctance to invest.”

Taking this further, for those uncomfortable going straight back into stocks, they suggest starting first on what it calls “equity-lite” holdings such as high dividend stocks, convertible bonds and high grade corporate debt.

What about Asia? Despite providing all the global growth in 2011, it also had all the worst performing stock markets, as people pulled money out and put it into supposedly safer assets in dollars. UBS is telling its private clients that Asia’s outlook for 2012 is “an oasis in the desert,” and “a clear standout with 6% GDP growth thanks to its internal strength,” according to strategist Yonghao Pu. But that’s not necessarily the same as good market performance: Asia delivered standout economic growth in 2011 as well and its stock markets plunged.

Citi Private Bank is telling its clients in Asia to be heavily overweight Asian investment grade fixed income (in dollars, but it’s also in favour of local currency); defensive equities; and – this is an unusual position – Japanese equities. It is heavily underweight cyclical equities generally, and also the stock markets of India and – wait for it – Australia. (That’s not a particularly widespread position; at the same time HSBC is telling its clients Australia will have “another solid year”.)

Despite the fact that China grows at more than 8% and the USA barely at all, we may see a similar pattern to last year. “Current expectations for higher earnings in the US and lower earnings in Asia suggest that the US will continue to outperform and that Asia will do the opposite,” says John Woods , chief investment strategist for Asia Pacific at Citi. Bonds, though, look good in Asia. “Local balance sheets remain in generally good shape and are likely to avoid the kind of over-leverage event risk that is likely to impact developed markets, particularly Europe,” he says. Unlike Deutsche, he favours low risk: sovereign or corporate issuers with strong domestic growth stories; and investment grade.

Pu at UBS is thinking more along Deutsche’s lines, expecting risky assets to deliver better performance in 2012, and specifically expecting developing Asian equity markets to perform better than developed neighbours. UBS is also recommending investment grade Asian bonds and selected quality high yield names (some would consider that an oxymoron).

Some are very positive about Asian equities: Dylan Cheang at RBS, published on January 4, called for 26% potential upside in Asian equities in 2012. It could get worse first though. “In a worst-case scenario, in which the debt crisis in Europe deteriorates further, we think regional markets could fall 15%,” he says. “But when this level has been breached historically, the rebound has been swift and decisive.” Wealthy clients are torn between this prospect of high bounce-back growth, and the more familiar ground of US large caps, who performed reasonably well last year, the banks apart.

One thing to note is that in this part of the investment world, people tend not to be satisfied with boring portfolios. “Managing money with just a simple 60/40% portfolio of stocks and bonds and a buy and hold approach has tended to deliver sub-par performance in 10 year rolling periods,” says Nolting. For many, this simply means adding more alternative assets: commodities, infrastructure, private equity, hedge funds. But even that’s an uncertain approach in a difficult environment; hedge funds in particular haven’t always proved themselves in volatile times over the last few years. “Adding more asset classes such as leverage-sensitive alternative assets can cause problems if they prove unexpectedly correlated,” says Nolting. “In very difficult and dramatic market circumstances, asset classes can get sold down together.” You don’t have to go too far back in time to find an example: that’s exactly what happened in 2008, and what many fear today.

For private clients generally, these days the absolute priority is not to lose their money. The wealthy were badly burned in the global financial crisis, with many of them having been advised to put their money in highly leveraged or structured vehicles which performed badly or even collapsed in 2008. In an uncertain environment, they’re unlikely to risk the same thing happening again and the mood among the wealthy appears to be: it’s risky out there.

Box: How family offices invest

At the top level of private wealth comes a structure called the family office. This is when a wealthy family incorporates its wealth into a separate legal vehicle, sometimes employing in-house staff to manage it, or other times employing external consultants. How do people like this invest?

“Everyone is different,” says Kris Vogelsong of Private Portfolio Managers in Sydney, which specialises in advising groups like this. “But we’ve seen the most success where people take a long term perspective with their investments rather than trying to affect an active trading policy.” At family offices, the mantra tends to be: don’t lose the wealth. Making more wealth is, if anything, somewhat secondary in the investment portfolio; the ways family offices have tended to build wealth is through their businesses, not by being sharp-shooting traders.

That doesn’t necessarily mean their portfolios look all that different to anybody else’s, although Vogelsong says that alternative investments tend to play a larger role. He notes, for example, that some clients are looking at distressed situations and mezzanine debts, which are difficult for mainstream investors to get exposure to. Not, though, structured products. “A lot of family offices did have a lot of exposure to those types of vehicles prior to the GFC and suffered losses,” he says. “There is strong resistance to instruments that are highly geared or aren’t transparent.”

Peter Reed, also at PPM, says that portfolios they provide to family offices tend to be quite concentrated, with just 20 to 25 individual holdings. “We don’t take the view that you’re controlling risk through diversification of individual holdings. We focus on the individual investments themselves, and the level of risks associated with them.”

Family offices also tend to have a clear focus on after-tax outcomes. “Tax is likely to be the greatest expense that any investor faces,” Vogelsong says. “So focusing on after-tax outcomes is a very positive way to create additional returns without incurring any additional risk.”