The saving of private clients

Jonathan Davis: A strong and vibrant economy, the emergence of an entrepreneurial culture and a protracted and powerful bull market in shares has benefitted the individual investor

The number of people in this country with substantial amounts of money to invest is growing rapidly, thanks to the potent combination of a strong and vibrant economy, the emergence of an entrepreneurial culture and a protracted and powerful bull market in shares.

The number of people in this country with substantial amounts of money to invest is growing rapidly, thanks to the potent combination of a strong and vibrant economy, the emergence of an entrepreneurial culture and a protracted and powerful bull market in shares.

The latter, operating through primary offerings, generous share options for management and unrelenting M&A activity, is the engine which has allowed more people to realise capital in this generation than in any comparable period.

One symptom of this spectacular growth in wealth is the emergence of a new business segment, asset management for high net worth individuals. The PAM directory of firms operating in this business says the amount of money managed by private client asset managers grew by 33 per cent in 1999.

Four firms, Brewin Dolphin, Merrill Lynch, Greig Middleton and Lloyds TSB, each have more than £10bn under management in this field. And the evidence is that this market still has plenty of growth.James Anderson, the editor of the PAM directory, believes only half the UK's "significantly wealthy" residents have so far been signed up by one of these specialist firms.

These firms offer clients a combination of tax, estate planning and investment advice that reflects their new circumstances. They are pointed in the direction of relatively low-risk strategies that put the emphasis on capital preservation rather than above-average market returns. Gone mostly are the days when those with new money were lured by Lloyd's of London, and invited to sign a blank cheque of unlimited liability in return for the prospect of unlimited further riches.

Or are they? It will be interesting to see, when the final audit of the great internet bubble is completed, how much of the money pumped into absurd new Net start-ups came from newly wealthy private investors. "When the frenzy is behind us," Bill Gates said prophetically two years ago, "we will look back incredulously at the wreckage of failed ventures and wonder, 'Who funded these companies? What was going on in their minds?' "

The difference between Lloyd's and the crop of Net stocks is that the losses on a foolish net investment are finite, but those of a Lloyd's syndicate member were not.

At the same time, sensible private client asset managers will steer their clients into a well-diversified range of assets, rather than exposing them to a potentially dominant single risk. One hugely positive effect of the financial revolution of the last 25 years is that there are liquid global markets in a much wider range of assets, which makes effective diversification a more realistic objective.

But there are still dangers for investors. Market risk has not disappeared. Were the stock markets to lose their frothy valuations, it would have a knock-on effect on almost every other type of investment. Liquidity for many types of asset would almost certainly start to dry up, which does not immediately damage investors' wealth, but extends the time frame over which it can be realised.

Second, the much wider array of investments to choose from is not all good news. The amount of money flowing into hedge funds has risen dramatically in the last few years, with high net worth individuals being a key part of the new client base. The story behind hedge funds - highly talented and motivated fund managers, good risk-adjusted returns, low correlation with the stock market - is a compelling one. They clearly have a place in the wealthy individual's portfolio.

They also carry hidden risks. The saga of Long Term Capital Management, which went in such spectacular fashion two years ago, demonstrated convincingly how easily even the smartest individuals can miss the flaws in sophisticated investment propositions, particularly when they are swayed by the snob or fashion factor of having their money in the fund where all the "movers and shakers" are also represented (Following fashion is the nearest thing to a surefire losing proposition there is when it comes to investing money). Arbitrage, the strategy LTCM was pursuing, is in theory a relatively low-risk low return strategy. Whether you are doing it in currencies, bonds, or equities, the essential feature of arbitrage is that you are taking positions where there is a high probability of a relatively small return, and a correspondingly low probability of a large loss. As the chart indicates, it is a strategy which tends to produce a fund which makes positive returns most of the time.

This looks great in the past-performance statistics, but when such a strategy misfires, it misfires badly, further compounded if, as happened with LTCM, the fund is highly leveraged with debt.

A third reason to worry about the great growth in private client asset management is the suspicion that, just as in mainstream fund management, the interests of the client and the manager/adviser may not always be one and the same.

The reason why so many top American and European firms are targeting the private client market is not just because the demand is there. The high fees UK private clients are prepared to pay is also a powerful driving factor. These fees are substantially higher than in the United States, and there is also evidence that clients may be less demanding or well-informed as well.

The bottom line is probably that the principles of sound investment practice - keep it simple, watch your costs, beware of fashion and know your risks - are the same however much money you have. If the growth in the UK private client business brings new standards of service and investment expertise to a wider audience, it will have a beneficial effect. Let us hope this is the way it goes.


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