The great rebalancing act

Private bankers, and the fund houses who try their hardest to enter into “consultative selling” partnerships with wealth management groups, are desperate to regain the trust of private clients which they lost during the crisis and through their exposure to excessive allocations of structured products, money market funds containing rogue, mortgage-backed assets and hedge funds exposed to Madoff and other questionable strategies.

“We are trying to position ourselves as a solution provider, tracking liabilities and arriving at optimal portfolio allocations for our clients,” confirms Leen Meijaard, head of international retail business at BlackRock, which since the purchase of BGI can provide active strategies, exchange traded funds (ETFs), hedge funds and private equity vehicles. Previously, the group had to buy in passive products from external parties, which was a harder case to present to distributors.

Combining strategies

“We can put together combinations of active and passive strategies, where we see a lot of interest right now. It’s a particularly efficient way to get emerging market exposure as quickly as possible,” comments Mr Meijaard.

His team has worked together with several different private banks to develop a model portfolio product using an iShares fund of funds, combining BlackRock’s asset allocation skills with passive exposure to underlying markets. “This is the direction in which the market is going,” says Mr Meiijard.

“It is definitely not a hype,” he adds, talking about the new policy of some private banks, including Holland’s Van Lanschot, to pass on asset manager commission rebates to their clients. He expects other Dutch institutions, including Rabobank to follow suit.

“They are moving to a model where the client pays the bank an advisory fee. Private and retail banks were previously reluctant to use ETFs, as there were no retrocessions attached,” explains Mr Meiijard.

This change to fee structures is part of a major rethink of private banking business models and how sound they are, according to Toby Pittaway, financial services partner at consultancy Oliver Wyman.

“It is no secret that nearly all private banks have been too margin driven. They have not been doing what is in the best interest of clients or they have been pushing clients into less suitable products,” says Mr Pittaway, who works closely with a number of wealth managers, trying to both improve their image in front of private clients and urgently address the problem of how to improve margins without selling risky products.

Currently, ‘boutique’ wealth managers have been taking advantage of the situation by suggesting to potential clients that only independent players can act in their best interests. Smaller advisers, such as Frontier Capital and 7IM, which use index-based products at the heart of low-cost, asset allocation-based portfolios, are also capturing the imagination of wealthy customers. Private clients are increasingly asking themselves why they should pay fees of up to 2.5 per cent to full service private banks, in addition to management fees to product providers, when the new breed of wealth managers charge closer to 1.5 per cent for allocation, transactions and administration, with almost negligible costs for running ETFs.

It is the job of Mr Pittaway to come up with ways the big boys can compete once more. One of the key routes which the banks have been advised to travel along is to emphasise their asset allocation capabilities. “A lot of people are talking about the importance of their asset allocation process. Some of this is clearly marketing rhetoric. But most banks are making the advisory process more institutionalised,” suggests Mr Pittaway.

“Rather than each adviser providing an allocation for their own clients, they are making it more systematic.”

However, he recognises it is tricky for larger institutions to establish a highly profitable, asset allocation-based offering, despite their public pronouncements. “This marks a big strategic change for suppliers of traditional packages,” warns Mr Pittaway. “They don’t want to reduce their pricing power, as the economics just don’t add up. But they see the smaller players coming in and taking away their customers, so they need to respond.”

Emerging market focus

One of the key recent changes in asset allocation thinking is that emerging markets, previously seen as a satellite asset class, has very much become the core of most private client portfolios. “Private clients are driven by recent performance. Certain asset classes like emerging markets are particularly attractive to them and yield-driven products like equity income have also proved quite popular,” he says.

“There is recognition that when we look at emerging economies in 20 or 30 years time, they will clearly be the core markets,” adds Mr Pittaway. “The news of Anthony Bolton and Fidelity launching a China fund is a good barometer of how far China has come.”

Since 2008, private banks began to look at purer building blocks in their model portfolios, in order to stabilise the structure and the returns this can generate, believes Alex Neve, head of product management at fund managers Robeco in Rotterdam.

“They made a distinction between beta blocks and core tilts for alpha,” says Mr Neve, adding that private banks initially found the beta exposure they needed through ETFs. But more recently he detects a shift away from passive to core active products among his private banking clientele, particularly on the equity side, although passive exposure bonds remains common.

“Private banks’ model portfolios underestimated the level of emerging markets exposure they got through traditional portfolios. In 2008, they got burnt, as global funds were so exposed to emerging markets,” recalls Mr Neve. “Now they want to know exactly what they are getting and make sure they don’t get too much of it.”

Recent months have seen the end of the alpha-chasing client mentality, believes BlackRock’s Mr Meijaard, who increasingly sees customers seeking to balance portfolios more effectively to achieve predictability of returns. “Customers want to build a stable, income generating portfolio, not chase the latest market trend or latest high performing manager,” he says.

“The feeling today is very different from a couple of years ago, when BlackRock’s clients were only looking for our energy-focused, blockbuster funds. Now they are buying a much broader range.”

Asian economies, with high growth potential feature strongly in the asset allocations of William De Vijlder, chief investment officer at BNP Paribas Investment Partners. “I am personally very passionate about emerging markets as they represent the future of financial growth and economic development,” he says.

While he approves of increased use of market timing, to get in and out of investments quickly, he believes many investors mistakenly see emerging markets as high volatility satellite investments, and fail to see the full picture.

“From an economic point of view, emerging markets are low beta, as their resistance to negative shocks is higher than in the Western world,” says Mr De Vijlder. Clients however, typically just see the high beta from a market perspective, as these countries are subject to a bigger swing when there are movements in the MSCI.

“Emerging markets have to be in the core of a portfolio for private clients in Europe. What you often see is people telling the portfolio manager, ‘this is my benchmark’, while giving the manager the possibility to take an off-benchmark position. But as a market timer, you need a high level of conviction before you go into an off-benchmark bet; that’s why I advocate its’ being brought into the core.”

Keeping things simple

Yet despite Mr De Vijlder’s devotion to acting only after analysing macro-economic data, he believes there are some bottom-up issues which should also influence investment decisions, such as the concentration of the portfolio. His belief is in simplification of portfolios to make them fully transparent to clients.

“People really need to understand – what am I buying here? This is particularly important from a liquidity perspective,” notes Mr De Vijlder. “Clients need to be sure they are able to get out of an asset class and that they know about any hidden risks.”

Yet there can also be too much focus on the intricacies of portfolio allocation rather than the main goal, which is making money, he adds. Capital preservation and certainty of returns is never quite enough. “I am thoroughly convinced that investment management, including management of private banking portfolios, should focus on delivering a return. The first part of the discussion with a client should be about what we can achieve over a medium turn, then we move onto asset classes,” adds Mr De Vijlder.

“Too often, private bankers get into a discussion with their client about whether they want to be in US bonds or emerging markets, forgetting that these are just a means to achieving a return.”

Time to rexamine fixed income

Many private clients have not acted quickly enough regarding fixed income and are over-reliant on the supposed safety of bonds in their portfolios, believes Mr Pittaway at Oliver Wyman. “Since the mid 90s, insurance companies and pension funds have been looking at shorter duration fixed income, but that has not yet fed through into the private client space,” he warns, with wealthy investors continuing to search for high yields through the purchase of corporate bonds.

This speed of response, a function of the decision making process, is also of some concern at Northern Trust’s wealth management arm, which runs portfolios worth $35bn for approximately 400 families around the world. Aïda Molineux, CEO of the American bank’s Emea business, says families increasingly make governance and due diligence decisions and have much more involvement in asset allocation and investment processes than before, especially in regions such as the Middle East, where there is a trend for wealthy individuals to take charge of their investments.

“But you need to end up with a balance,” says Ms Molineux. “Some family offices were more nimble at the end of 2008. Many were consciously looking at asset allocations, getting out of investments and into cash. They could do this quickly, as they didn’t need to go through the process of a trustee meeting, like an institution would. But there is an inconsistency. Some family offices did this much better than others, who were not focusing on it. Those who got burnt, got burnt very, very badly.”

Fear of further losses fuelling risk aversion levels

Clients are displaying much higher degrees of aversion than before the crisis, says William De Vijlder, chief investment officer at BNP Paribas Investment Partners, their main concern being not to repeat the huge losses most incurred in 2008, rather than achieving the equity risk premium prevalent over the last 10 to 15 years.

“When you are living in normal times, diversification allows you, for a given risk acceptance level, to take more exposure to asset classes with a higher expected return. This is a fundamental strength of diversification,” says Mr De Vijlder. “This creates a cushion by squeezing out more risk premia in good times to resist problems in bad times.”

However, increased risk aversion has led private clients to feel that “when the market’s going up, it’s going up big time and when it’s going down, it’s going down big time. This gives some sense to clients in looking for more stability and consistency in returns,” with an emphasis on downside protection, which can be achieved through structured products using CPPI mechanisms.

This asset allocation discipline is coming into its own more than ever before today, believes Mr De Vijlder, who thinks many asset management groups have failed to share their research with both staff and clients. “Perhaps this is something that has been neglected in the past, but sales teams and clients need access to a chief investment officer,” says Mr De Vijlder.

“I don’t want to portray myself as somebody sitting on a throne in an ivory tower, but I need to help find the appropriate asset allocation solutions for specific clients.”

The top-down philosophy is augmented by FundQuest, the multi-manager unit of the French bank, which allows clients to switch between funds to exploit market timing opportunities in order to create alpha.

Clients reluctant to blindly follow allocations

Jhon Mortensen, CEO for the international private banking arm of Scandinavian wealth manager Nordea, says there has been no change of focus in the way his relationship managers have dealt with clients, with alpha creation against a low-risk background still a priority. What has changed though, is the increased client interest in the asset allocation process, which has come very much into the forefront.

“Both account managers and their clients are more concerned about which funds they are invested into,” says Mr Mortensen. “We have seen a slight reduction in numbers of funds, but people are more critical of the performance of these funds.”

Clients are also reluctant to blindly follow asset allocations laid down by discretionary managers, with Nordea trying hard to boost the 20 per cent of its clients currently signed up to the regular fee-generating discretionary model. “We believe a client is better off with a discretionary mandate rather than running the money him or herself,” says Mr Mortensen, although he admits it is proving difficult to change the mentality, following a crisis leading to a mass loss of trust between clients and their advisers.

“The main thing you can sell in a private bank is trust. But to trust someone with your money – or your wife – is the hardest thing you can do in life and it takes time to earn that trust.”

Switzerland’s Vontobel private banking group has also noted distrust from private clients who lost money in discretionary portfolios and is advocating a hybrid solution.

“Clients want to tap into a model portfolio, using the know-how of the bank, but they want to tailor their own holdings,” says Vontobel’s head of private banking Peter Fanconi.

William De Vijlder, BNP Paribas Investment Partners