Keeping cool on risk

Forget service, alpha extraction and exotic investment opportunities. The new buzzword for banks and wealth managers running assets for private clients is ‘risk.’

This sometimes elusive, but crucial, concept is once again coming to the centre of the client-adviser relationship. How to control it and to set up a benchmark, which identifies a client’s tolerance to it, before an investment programme begins, are the two questions which most practitioners are asking.

The assessment and management of risk is also tied in with another concept which is not always correctly put into practice – that of asset allocation.

“Particularly from the private client perspective, risk is the absolute hot issue,” says Guy Monson, group chief investment officer for Swiss private bank Sarasin. “There are several factors which are coming together to make this the apex of our discussions.”

Although many clients held their nerve when markets crashed, and did not sell at the bottom, with managed funds now at all-time highs, some are wondering which strategy to adopt going forward, claims Mr Monson.

They are also asking long-overdue questions about benchmarks. “Pre-2001, the entire private client world was made up of relative investors following a passive benchmark. The words ‘absolute return’ had not yet been invented.”

‘Absolute return is not income producing. There is no yield to speak of, which is often an essential requirement of wealthy individuals.

Also, the hedge funds and derivatives which these strategies are composed of are largely “black box”’

Guy Monson, Sarasin

Taste of the old growth

But the absolute return mandates into which investors were guided by their bankers, following market crashes, have also proved inadequate for their needs.

“Absolute return is not income producing. There is no yield to speak of, which is often an essential requirement of wealthy individuals,” believes Mr Monson. “Also, the hedge funds and derivatives which these strategies are composed of are largely ‘black box’. If you had to ask how GAM or Man make their money, the man on the street could not tell you.”

Mr Monson also believes absolute return benchmarks, which forbid any short-term negative returns, are actually too low-risk for most private client needs.

“If you have long-term money to invest, do you really mind if you take an absolute loss over 12 months? For most clients it’s overkill, particularly as global equity accounts are up 50 per cent over the last three years, so people are getting a taste of the old growth.”

The preferred benchmark currently being touted by Mr Monson and his investment staff is that of Inflation Plus, where client and adviser take the rate of inflation in their country, and then add on as many percentage points as they think realistically demonstrate the price rises they are subjected to in their lives.

Liability-driven mandates

In this way, private clients and their wealth managers are effectively building liability-driven mandates, managing assets with a yield to take care of regular payments such as hospital bills or school fees, yet taking account of rising prices.

“Most private clients have the feeling that their personal rate of inflation bears very little resemblance to central bank base rates,” says Mr Monson. “Most people’s annual cost base typically goes up by inflation plus 5 per cent.”

Any benchmark of inflation plus three or below can be managed almost purely through bond exposure. But clients requiring 4 or 5 per cent above official retail price indices need equities, although these bring volatility with them.

Inflation plus five, for instance, requires 50 per cent exposure to global equities, an asset class which has experienced losses of more than 6 per cent three times in the last 25 years.

This is where asset allocation needs to be introduced to reduce volatility, and Mr Monson believes cross-border mutual funds, which incorporate the latest European Ucits III legislation, are the best-placed to operate in this way.

“Ucits III is an absolutely smashing piece of legislation which allows us to tackle a complex issue,” says Mr Monson. “Whereas Ucits I allowed us only to use derivatives for efficient portfolio management, III says we can buy them and keep them, plus we can have as much cash as we want. This encourages an asset allocation approach.”

Invesco, another group very active in the European wealth management arena, agrees on the importance of the new legislation. “Ucits III brings an opportunity for fund managers to use a greater number of instruments, for example for fixed income and protected vehicles,” says Jean-Baptiste de Franssu, CEO of Invesco’s Continental European operation. “There are things you can do now, which you could not do before.”

Limited influence

However, Invesco does not get carried away with the concept of controlling risk, saying that manufacturers may not always have as much influence as they wish on their distribution partners.

“Risk control is probably something private banks do internally,” says Mr de Franssu. “We don’t automatically know what drives their product requirement, as we are not party to their full decision-making process. Of course we would like to be more involved in their process, so we can add value.”

Invesco has been using some of the feedback from private bankers such as Deutsche to group its product offerings under two main themes.

“The first is ‘protect my capital’,” says Mr de Franssu. “The objective of these products is to achieve capital protection. Once we have looked at this, the next brick is ‘give me more alpha!’ That’s the way we go about thinking about our product range.”

Falling into the first bracket is the Capital Shield, protected, actively managed concept. This has gathered $2bn (?1.7bn) in European-sourced assets, which Mr de Franssu believes would otherwise have gone to local players supplying structured products, originated by investment banks.

This move into structured products, by active investment houses with expertise in pooled funds, is becoming more common-place in Europe.

The best example is Société Générale’s asset management division (SGAM), which has already built up ?35bn since forming a specialist alternatives department combining hedge funds, private equity, property and structured products in 1998. The target is to manage ?50bn by 2008. Currently more than 35 per cent of these assets are held on behalf of retail or private clients.

“These disciplines can be an alternative to bonds rather than equities,” says Jean-Cristophe Ginet, head of SGAM Alternative Investments (SGAM AI). “Markowitz’s classical portfolio theory shows that to add a small part of alternatives to a portfolio can help improve the risk/return profile.”

SGAM strategists believe that much of its potential growth can come from wealthy individuals, for whom they currently manage ?1.2bn in structured products. The aim is to double this by 2008. “These are the best-selling products in France at the moment,” says Franck du Plessix, head of structured products at SGAM AI.

He is witnessing a change in behaviour of rich private clients and family offices, which he says are increasingly behaving like institutions. Rather than just chasing returns, these clients are increasingly using structured products to enhance the risk-return ratio of their portfolio.

‘A family office has the ability to change an underlying. They can start with a basket of five hedge funds and can change to a different basket if they need to. An adviser from a family office will always tell you what they want in the basket. The adviser will ask for a different allocation every few months. This level of flexibility is a big plus’

Franck du Plessix, SGAM AI

Dynamic allocation

This control can be achieved through dynamic allocation of underlying assets, says Mr du Plessix. “A family office has the ability to change an underlying. They can start with a basket of five hedge funds and can change to a different basket if they need to. An adviser from a family office will always tell you what they want in the basket. The adviser will ask for a different allocation every few months. This level of flexibility is a big plus.”

At UK high street bank Abbey, a key distributor of investment products, chief investment officer James Bevan is a cautious advocate of this approach.

“The single largest areas of structured product design and manufacture which have not generally been open to investors in the UK are risk-controlled participations in actively managed funds,” says Mr Bevan, who is working closely with his parent group Santander to develop a new range of risk-control solutions for retail customers.

“Most structured products in the UK are based on benchmark indices, but in a world with appropriate focus on value added, it is inevitable that structured products should be designed to provide customers with the opportunity to benefit from skill.”