High net-worth (HNW) investors are a different breed than other investors. Simply put, HNW investors have significantly more money. Their wealth affects their willingness and need to take risks, and also widens the range of investment opportunities available.
The manner in which HNW clients' assets are held also is different. Publicly traded stocks and bonds still make up the bulk of these clients' assets, but the investments are available through lower-cost pools offering discounted fees that decrease as the amount invested rises. These core assets often are complemented by alternative investment "side dishes" intended to augment income and tame volatility overall within a portfolio. And clearly, alternative investments are becoming more popular. According to research by Toronto-based Strategic Insight Inc., Canadian-managed alternative assets more than doubled to $188 billion as of June 30, 2016, from $84 billion in 2011.
The alternative asset class includes investments ranging from aggressively leveraged strategies to products offering stability and downside protection. Due to large minimum investment requirements or accredited investor restrictions, many of these alternative assets grant HNW clients access to money managers and assets beyond the reach of unqualified retail investors who have fewer investible assets. Adding private equity or debt to a HNW client's portfolio also may mute the influence of public trading markets, within which valuations can fluctuate quickly and volatility is more pronounced.
Other alternative investment choices include physical assets with low correlation to financial markets, such as commodities, real estate, infrastructure, timber, farmland or agriculture. Some of these assets are liquid and trade in public markets on a daily basis; others are held in partnerships or pools that may require investors to commit their money for several years before they can cash out.
Financial advisors specializing in HNW clients find that wealthier people with large investment holdings don't need to buy and sell on an intraday or daily basis - and can sacrifice some liquidity for potential higher returns in assets that are sold or redeemed less frequently. For example, 70% of an average portfolio held by a client of Vancouver-based Nicola Wealth Management Ltd. would be cashable daily or weekly, and 30% would be cashable monthly, quarterly or yearly.
"Too much volatility can cause investors to panic and bail out at the wrong time after a sharp drop [in the market], which means they don't participate in the subsequent recovery," says John Nicola, the firm's chairman and CEO. "We emphasize extensive diversification across many different asset classes and stable, predictable cash flow. This tends to keep our clients invested and allows their money to keep working for them while providing the income they need."
In recent years, geographical diversification in equities has provided little protection to investors when stock markets tank because various regions of the world are becoming more closely linked. And although bonds once were thought of as an effective diversifier when paired with equities - with 60% equities and 40% bonds composing a typical balanced allocation - bonds come with their own set of risks, particularly in today's low interest rate environment. With interest rates likely to rise rather than drop, the market value of outstanding bonds is vulnerable to decline.
"Investors want extra returns, and it's hard to get those in a 60/40 world," says Dan Geraci, managing partner with Cygnus Investment Partners LP of Toronto, which offers Canadian institutional and HNW investors access to the alternative product shelf provided by New York-based investment giant KKR & Co. LP (formerly Kohlberg Kravis Roberts & Co.) through Canada-domiciled products. "That's why we're turning to alternatives. These are not well represented in many portfolios, but we look to where the market is going, not where it's been."
Nicola says stocks and bonds usually account for less than half of his clients' portfolio allocations, but the mix can be adjusted depending on a client's planning needs and the other investments within the portfolio, such as real estate, business holdings or individual stocks. Nicola Wealth Management's model core portfolio includes infrastructure, commercial mortgages, direct real estate ownership, private equity, private debt, long/short equity, global bonds, preferred shares and a small slice of gold.
Nicola Wealth Management's core model - which echoes the firm's asset-allocation philosophy - features the realized returns of clients who followed this model, Nicola says, delivered an average annual return of 7.3% from its inception in 2000 through May 31, 2017. Typically, a client withdraws income equivalent to 4% of his or her portfolio's assets annually - income composed of dividends on equities, interest on debt and rents on real estate - leaving the balance to grow.
However, alternative investments may pose their own risks, including lack of liquidity, magnification of both positive and negative returns through leverage, or project/business risk. Some investments offer defensive strategies or downside protection that may bolster a portfolio in bear markets, but cause a drag in hot markets by limiting exposure or adding to costs.
The key is to help your HNW clients attain their goals while taking no more risk than necessary. In fact, some HNW clients are unnecessarily aggressive in their portfolio holdings, taking more risk than they should, says Dan Hallett, vice president and principal with HighView Financial Group, a boutique wealth-management and investment-counselling firm based in Oakville, Ont. There's a contingent of clients who embrace risk to an extent Hallett is uncomfortable with and, he says, in some cases, that's a reflection of the personal characteristics that helped those clients achieve financial success.
"Many high net-worth clients have worked hard and taken risks to accumulate the wealth they have," says Hallett. "We want to help them achieve their income goals and preserve what they worked hard to accumulate without taking the risk of having to build their wealth all over again."
Rick Claydon, financial advisor and managing director with Stonegate Private Counsel, a division of CI Private Counsel LP in Toronto, puts his HNW clients through what he calls "stress tests" that demonstrate hypothetical market scenarios and show clients how much their portfolio values could decline in dollar terms if there was a repeat of a market crash similar to that of 2008-09, for example. "With high net-worth clients," he says, "the No. 1 goal is preservation of capital."
Private-equity pools contain both successful and less successful holdings, just as a stock-based mutual fund would. Although private equity may not fluctuate in value in the same manner as a stock, there's no guarantee that private equity will offer better returns in the long run. Thus, Claydon limits that exposure to 5%-10% of a client's portfolio.
"We build a core portfolio and add some non-traditional holdings around the fringes, but core fixed-income is the stabilizer," says Claydon, who normally recommends a 40%-50% exposure to bonds. "If we can stabilize the portfolio, we keep the client emotionally intact so he or she doesn't make silly decisions trying to preserve capital when markets are volatile."
For clients' portfolios, HighView often employs a handful of individual bonds held to maturity and redeemed at par at a predetermined date. These can be a more attractive, reliable option than bond-based mutual funds, pools or ETFs that offer diversified bond portfolios that change value according to market conditions and have no maturity date.
THE ETF ADVANTAGE
ETFs are a convenient and inexpensive way for high net-worth (HNW) clients to access a wide swath of investment strategies - from simple to sophisticated.
ETFs meet the needs of affluent clients for both core and niche holdings in their portfolios. These investments offer convenient, low-cost access to a variety of strategies, ranging from cash-like securities to alternative investments that once were the exclusive domain of high-fee hedge funds.
Although the majority of ETFs focus on equities, clients are discovering these products' benefits for fixed-income exposure as well. Product choice includes government and corporate bonds and specialized categories, such as high-yield or floating-rate bonds.
With a single purchase of a bond ETF, everyone from small investors to wealthy individuals and even large institutions can access a diversified bond portfolio faster and at a far more efficient price than through assembling a comparable basket of individual bonds in the scattered, cloudy and often illiquid over-the-counter bond market.
In the current low-yield investing environment, the cost savings inherent in fixed-income ETFs can have a big impact on portfolio returns.
"Fixed-income is becoming an important asset class within ETFs, and investors are using ETFs to seek more precision than is offered by the aggregate bond index," says Kevin Gopaul, senior vice president, quantitative strategies and global ETFs, with Bank of Montreal in Toronto. "ETFs offer various ways to target duration as well as deliver enhanced yield through high dividend, covered-call strategies or access to preferred shares."
ETFs employing passive index-based strategies often are used for broad, core exposure to stocks and bonds - the average market returns of which higher-fee, active fund portfolio managers traditionally have found challenging to beat. However, the evolution of ETFs beyond plain-vanilla offerings to include a wide variety of strategic beta and actively managed products has attracted more adventurous HNW clients who want broader diversification, lower volatility or an opportunity to beat the market.
ETFs can be used to target specific investment styles, such as value or growth. Clients can use ETFs to add a slice of a narrow market niche, such as emerging markets, to achieve exchange-rate protection or hedge against downdrafts in financial markets. ETFs also offer low-cost access to non-correlated areas, such as commodities and currencies.
The effect of ETFs' lower management expense ratios relative to mutual funds is magnified by HNW clients' greater investment capacity. A single percentage point reduction in annual fees can translate into thousands of dollars a year within a millionaire's portfolio.
Some ETFs are designed to be tax-efficient, and this can be an important consideration for HNW investors. To achieve this goal, many ETFs employ passive strategies based on market indices that tend to have low trading turnover.
Unlike hedge funds and many other alternative investments, the ETF structure offers the advantage of having no investment minimums or mandatory holding periods.
"ETFs are a great alternative to hedge funds for some exposures due to their intraday liquidity and low management fees," observes Mark Noble, senior vice president, sales strategy, with Toronto-based Horizons ETFs Management (Canada) Inc.
Although HNW clients often seek to enhance portfolio returns through the use of alternatives beyond traditional stocks and bonds, ETFs are not suitable for accessing highly illiquid investments such as private equity, private debt or physical real estate assets. Difficulties can arise if the ETF portfolio manager is unable to match the limited liquidity of the underlying asset with the sales and redemptions of ETF units, particularly in times of heavy ETF buying or selling.
Only certain alternatives, such as market-neutral and long/short strategies, commodities and global currencies, are sufficiently liquid to suit the ETF investing structure, Noble says.
Among the several Horizons ETFs linked to hedging strategies is Horizons Morningstar Hedge Fund Index ETF, which replicates the performance of the Morningstar broad hedge fund index created by Morningstar Inc. of Chicago.
This ETF uses derivatives to track the combined performance of the 600 to 800 hedge funds that compose the index and thus avoids potential liquidity issues by not holding actual units of the underlying hedge funds.
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