Pouring money into alternatives

When mobile phones first came on the market, they were the playthings of the very rich and the very eccentric. The rest of us eyed them with doubt: they seemed clumsy to use, prohibitively expensive and probably dangerous. No-one really understood how they worked and we did not think we needed them anyway. Now, every man, woman and 12-year-old child has one, and feels naked if they leave the house without it.

It is like that with alternative investments. The asset class went from little-known, much-feared wild card, to established diversification tool, and now deserves a name-change, being almost as mainstream a component of the high net worth individual’s portfolio as bonds or equities.

The average allocation on behalf of a balanced private banking client to alternatives is 21.63 per cent, according to those four major cross-border banks who disclosed the figure (see Charts 1c–f). That compares with an overall average of 40.5 per cent for equities and 30.42 for bonds (see Chart 2).

“People are now looking at these asset classes more as a part of the portfolio than as a sweetener,” says Youssef Affany, senior investment counsellor for Citigroup Private Bank Europe.

Jan-Marc Fergg, executive director, investment solutions, at UBS Wealth Management & Business Banking, agrees. “It is a trend,” he says, “and we expect it to continue.”

Private banking clients are in it for the absolute returns. It is these returns that make alternatives so particularly attractive. “The typical successful entrepreneur built his wealth over the last 25 years with lots of sweat,” says Mr Affany. “All his career he has been looking at outright returns on investments. He really doesn’t care about benchmarks.”

Risk-adjusted returns

The emphasis, Mr Fergg adds, is on capital preservation and managing downside. “Alternatives, and in particular funds of hedge funds, are very good instruments to support this purpose and to deliver higher risk-adjusted returns even in declining markets,” he explains.

Within alternatives, the biggest area is hedge funds. Citigroup recommends private clients invest 12.5 per cent in hedge funds, and Deutsche Bank, at least for international clients, a hefty 20 per cent (Charts 1d and 1e). UBS, according to Mr Fergg, allocates “an appropriate portion” to them. A reasonable estimate would put it at up to 10 per cent, depending on client profile.

Nor is this an asset class just for the risk-taker. On the contrary, low correlation to major markets and the ability to control manager risk within the asset class make hedge funds a tool for even the most cautious of high net worth individuals (HNWIs).

Even for a conservative investor, JPMorgan would advise assigning 15 per cent of the portfolio to alternatives, says Tim Harris, Europe, Middle East & Africa equity strategist at JPMorgan Private Bank. This compares with a 20 per cent benchmark allocation for a moderate risk profile, and 25 per cent for an aggressive one.

^{The main point is to get the style allocation right within hedge funds}

^{Klaus Martini, Deutsche Bank}

Citigroup’s allocation to hedge funds remains significant across all five investor risk profiles (see Chart 3), and the highest share (17 per cent) is for a relatively risk-averse level 2 HNWI, seeking capital preservation and income generation. It is private equity allocation that grows dramatically as the client becomes more risk-loving in pursuit of long-term growth, from nothing for the most conservative to 22.5 per cent for level 5 investors.

But the main point is to get the style allocation right within hedge funds. So stresses Klaus Martini, global chief investment officer for private clients at Deutsche Bank, whose current recommendation would be 8.5 per cent to relative value, 8.5 per cent event-driven and 3 per cent equity hedge funds.

Outside alternatives, the main theme is a shift away from domestic into international equity. Private clients, says Citigroup’s Mr Affany, “are opening up more and more to global investments”.

Eggs in many baskets

Diversification, according to Mr Fergg at UBS, is “a concept which has been reconfirmed. It was previously not really properly followed by many”. The emphasis now, he says, is on diversification not just in terms of asset classes but also in terms of geography.

Mr Affany is confident the trend will continue. “Decision making today is done on a global basis,” he explains. “Every morning I come in, I open Bloomberg and I see the same information that some person in New York, some other person in Geneva, another in Tokyo and another in Hong Kong, is seeing.

“We all respond to the same stimuli so the information taken into account is global. The result is, by definition, the decisions taken will be global.”

Alongside the international shift is a change in perception by European HNWIs. “We have seen a trend where, especially in Benelux, France, Germany and Italy, clients have changed their definition of domestic,” Mr Affany adds. “They are starting to think of Europe as their domestic market.”

In general, the banks are fairly neutral on equities. The average allocation comes out at 40.5 per cent and although Merrill Lynch is above its stated strategic allocation (Chart 1b), JPMorgan and Deutsche Bank are exactly on theirs (Charts 1e and 1f). “We recently took down our overweight in equities,” Mr Martini adds.

Positive on japan

According to Mr Affany, Citigroup “likes equities overall over bonds but that is simply because we don’t like bonds. It’s a no-brainer. But we did have to scratch our heads over the regions.” Citigroup is moving up on Japan “little by little”. (JPMorgan, by comparison, is already overweight, with 5 per cent rather than its benchmarked 3 per cent for the country.)

^{‘Clients have changed their definition of domestic. They are starting to think of Europe as their domestic market’}

^{Youssef Affany, Citigroup}

Mr Affany adds that the bank is positive on Asia ex-Japan, regards the US and Europe as so correlated one “can even think of them as the same market, although we still try to differentiate”, and is keenest of all on investments in emerging markets.

^{‘There has been some trend from fixed income into equities... We feel this will continue’}

^{Jan-Marc Fergg, UBS}

Mr Fergg at UBS reports signs of increased optimism which, coupled with lower returns on high quality bonds, could mean a move back into equities. But investors are waiting “for the economic recovery to be confirmed”. Moreover, he stresses: “We do not really believe that we are going to return to a situation like in 1998 or 1999, in terms of the perception that there is no risk associated with equities.”

^{‘If European equities fall then obviously the vanilla allocation will participate in the downside’}

^{Tim Harris, JPMorgan}

JPMorgan has tackled uncertainty over equities by pushing 5 per cent of clients’ assets into structured equity products that protect against downside risk at the cost of some upside. “It neutralises the equity base,” says Mr Harris. “If European equities fall then obviously the vanilla allocation will participate in the downside but the structured equity products put the handbrakes on.”

Hold back on bonds

If the future is bright for alternatives, then it is – or at least it is in the near-term – decidedly cloudy for traditional fixed income investments.

Average bond allocation for the six banks surveyed is 30.42 per cent (see Chart 2). Merrill Lynch, Deutsche and JPMorgan are all underweight their strategic fixed income allocations (Charts 1b, 1e and 1f).

Significant cash pools allow banks to jump back into equities as and when they want.

“There has been some trend from fixed income into equities,” says Mr Fergg. Within the asset class, he says, clients are tending to move from top quality bonds towards convertible, corporate or high yield bonds. “We feel this will continue.”

For a client with a moderate risk profile, Citigroup allocates 9 per cent to US and 23.5 per cent to other bonds (Chart 1d). Mr Affany, although he does not much like bonds, would, naturally, not advocate getting rid of them altogether.

Citigroup recommends, rather, that clients “keep some but reduce duration to the minimum – we do not want interest rate exposure there – and trade some exposure for alternative investments.” So we come back again to alternatives – and the fact that there is no longer anything alternative about investing in them.

Behind the numbers

It is difficult to draw fair comparisons between private banks. Asset allocation comparisons get complicated when, for example, it is not known which underlying asset classes are represented by UBS investment funds, or by Merrill Lynch’s unwillingness to break down its “other assets”. In addition, Deutsche Bank’s figures are for offshore, international, clients.

Figures for assets under management tend to vary from bank to bank, in terms of what is or is not included. (To count all client assets, including brokerage, for JPMorgan, would put its figure up to $266bn (E224bn) and bump Deutsche Bank out of fifth place – hence the decision to include all six banks.)

Moreover, there is a massive disparity in terms of which type of client a bank accepts. Citigroup might fairly claim to be the most private of the private banks, limiting itself to the top echelon of international clients, with investable assets starting at $5m to $10m.

Merrill Lynch figures, on the other hand, include clients with down to $500,000, and HNWIs need only E165,000 to get through the doors of UBS’ wealth management arm.

For all this, it is possible to pick out the clear trends. Clearest of all is the ever-increasing prominence, across all risk profiles, of alternatives in general, and hedge funds in particular.