In a previous article (Private Wealth Management) we explored the failings of the current model of wealth management in Asia. Now we look at possible solutions.

 

Regaining Investors’ Trust:

 

For reasons of alignment of interest, the ideal model of an Asian wealth management business would always ultimately involve the deployment of the firm’s own capital in the same or related investments as that offered to its clients recalling  the merchant banking model of the 1980s. The level of mistrust of financial advisors in Asia resulting from the experiences during the financial crisis in 2008 require such alignment of interest in order to restore the trust between principal and agent. A more direct alignment between principal and agent can be achieved by requiring or encouraging staff to invest alongside clients. The bonus pool is a convenient pool of staff capital that can be deployed to this purpose.

 

 

Building Long Term Relationships:

 

Staff turnover in Asian private banks is acutely high and confounds the objective of building lasting relationships. Bankers retain their relationships instead of transferring them to the firm. The result is a constant rotation of clients through firms as their relationship managers rotate. An appropriate compensation scheme for talent acquisition and retention and alignment of interest would involve partial retention of bonuses which would be invested in the firm’s products or services.

 

 

Winning Discretionary Mandates:

 

While there is a proliferation of private banks in Asia, most of them are in fact expensive retail brokerages with a small percentage of their revenues coming from traditional private banking services. Discretionary investment management mandates are difficult to win and grow as discretion requires more trust than clients are currently willing to bestow.

 

Discretionary mandates need to be won in stages. Asia’s wealthy families are mostly first or second generation wealth and continue to grow their operating businesses. This provides a strong pipeline both in the demand and supply of PE directs. This deal flow presents the opportunity for a wealth management firm to bootstrap its business with a placement and advisory business where it provides due diligence and cornerstone capital to transactions which are then syndicated to its clients. The client base itself as well as selected GP partners are a rich source of origination. The discretionary asset management business can be built upon the foundations of a successful placement and advisory business. It is important to differentiate this business from the low value-added, low margin discretionary portfolio management services offered by garden variety asset managers. There is a dearth of absolute return, long term, policy mandates designed for long term legacy management while controlling downside risks to avoid interrupting the compounding effect. Alternative investments are under-represented in garden variety discretionary portfolios. Anyone who has done an unconstrained optimization will obtain significant allocations to alternatives, allocations which are often suppressed in traditional portfolios for no other reason that the investment manager is patronizing and pandering to their expectations of client sophistication. This is counterproductive to client objectives and to the managers’ fee margins.

 

Difficult market conditions and negative past experience with private banks have driven up liquidity and control premia in Asia. Investors are acutely more willing to invest in very liquid investments, substituting this liquidity away only in investments where they have extraordinary transparency and control. Quarterly and monthly redemption hedge funds are notoriously difficult to raise capital for. So too are long duration blind pool PE funds. Investors tend to favor daily liquidity funds or if they invest in private equity, prefer directs to funds where they often seek some level of control. A positive experience needs to be built with investors before discretionary mandates can be won.

 

 

The Asian International Nexus:

 

Asian wealth management sits on a goldmine of investment opportunities which exceeds the regions ability to absorb them. Diversification also advises Asian investors to invest at least a portion of their assets elsewhere. European, US and LatAm investors, however, are seeking Asian investments, and often require help in due diligence and deal analysis to weed out unsuitable investments. The Asian wealth manager may seek to place Asian investments internationally, helping businesses to diversify their investor base.

 

Asian investors’ international experience is yet immature and a significant proportion of them do not plan to diversify internationally. The propensity to venture abroad comes with understanding. The Asian wealth manager should invest in the education of their investors to bridge this gap. In fact, investor education is an important component of any credible wealth management business, not merely to bridge immediately evident gaps, but to maintain the level of sophistication of the partnership.

 

 

Fear of the Road Less Travelled By:

 

Asian private banks have been active since the mid 1980s. Few have broken out of being a transactionally driven brokerage business with expensive products, services and staff. Management have taken the international private banking model and attempted to get there in a straight line. In doing so, and ignoring cultural factors, they have created their own impediments, which they now cannot recognize or address satisfactorily. A different approach needs to be taken which puts the client first in practice and theory, and not just in rhetoric. The path is easy to see, its just very difficult to take.

Uncertainty and the Futility of Having A View.

 

Financial markets are highly uncertain today. As the great workout of 2008 continues to unfurl, the interplay of politics and policy on economics has blunted the traditional methods of fundamental analysis and asset allocation.

While the investor who is able and willing to invest in hedge funds can still make a decent return without being forced into taking inordinate risk, the investor in traditional asset classes is faced with high uncertainty as to the returns prospects of equity and debt investments. In response to this more uncertain landscape, we approach the problem of a long term policy portfolio from a simpler, and arguably simplistic approach seeking a portfolio construction that is more parsimonious and which uses only the information we have and are confident about, and disregarding the information we have not or are less confident about.

 

 

The Construction of the Risk Neutral Portfolio.

 

We consider a world where we can invest in equities, bonds, commodities and absolute return alternative investments. We have excluded less liquid asset classes such as real estate and private equity.

 

• We will not impose any expectations for the asset class returns, only that they are positive.
• We have chosen to arbitrarily assume a long term mean of 4% p.a. This has no bearing on the actual calculation, it is a convenient and reasonable number. The point of making all ex ante expected returns equal is that we provide no expectations to the optimization problem.
• We have expectations as to correlations based on historical correlations and we amend these according to our understanding of asset class inter-dependencies.
• We have expectations for volatilities based not on historical volatilities but based on the levels of volatilities at which the asset class becomes a concern to us.
• Note that we have used substantially higher correlations between fixed income and all other asset classes as we believe that the sensitivity of fundamentals and asset prices are considerably greater now than ever.

 

 

Correlation Table:

 

 

 

 

 

 

 

 

Asset Allocation Table:

 

 

 

 

 

 

 

 

Asset Allocation Chart:

 

 

 

 

 

 

 

 

While the allocation to bonds looks inordinately large it is in fact contributing the same marginal risk to the portfolio as the 3% commodities allocation or the 10% equity allocation. The whole point of this exercise is that each asset class is contributing the same amount of risk to the portfolio. We chose this by design since we had no prior view on the relative performances of the asset classes.

 

 

 

Extensions:

 

We can extend the methodology to building an equity portfolio, a fixed income portfolio and indeed an alternatives portfolio. By iteratively separating the portfolio to its components and applying the risk neutral methodology, then reconstructing the portfolio, one can arrive at an efficient portfolio which is view agnostic.

 

 

Equity Asset Allocation Chart: (This can obviously be performed with more sub-categories as desired.)

 

 

 

 

 

 

 

Fixed Income Asset Allocation Chart: (This can obviously be performed with more sub-categories as desired.)

 

 

 

 

 

 

 

Putting it all together:

 

 

 

 

 

 

The Use of the Risk Neutral Portfolio:

 

 

1. You should use the Risk Neutral Portfolio if don’t have view or if you do but you don’t have a lot of confidence about it.
2. Undoubtedly, you will have a view. The Risk Neutral Portfolio is a minimum variance portfolio around which your tactical views can be built. Tactical trades can be appended to the Risk Neutral Portfolio to express your tactical view.
3. The current environment favors this approach whereby a stable core portfolio is held to fund tactical trades which tend to be short duration in nature to capture event driven opportunities. Cash is a poor core portfolio as inflation risk has increased with successive rounds of debt monetization (QE).
4. To scale your level of risk, there is no need to adjust the relative allocations. For a conservative, lower risk portfolio, a positive amount of cash should be held together with the Risk Neutral Portfolio. For a more aggressive, higher risk portfolio, a negative amount of cash should be held together with the Risk Neutral Portfolio (i.e. leverage should be applied.)
5. The Risk Neutral Portfolio is best populated with appropriately chosen Funds. Direct securities are cumbersome to manage and require constant management, monitoring and rebalancing to handle index changes, bond maturities, corporate actions.

 

 

 

 

Having just read the article in the latest Economist magazine on Emerging Market economies creating a welfare state I started thinking about how economies mature.

I used to think that the sign of an economy maturing was the establishing of social welfare, a safety net. I think it is still true.

 

With the death of communism, capitalism has been left to grow uncontested and unquestioned. Unfortunately our best available system of economics seems to increase income and wealth inequality. Under capitalism there is no attempt to reduce it at all. So the Gini coefficient rises monotonically and social problems arise. At some stage in the development of a country, unfettered capitalism increases inequality to the extent that the masses, the underclasses, revolt. Governments are eventually faced with either providing a safety net, or establishing some form of redistributive policy. It is in the interests of the rich to support such policies that keep the poor at least marginally satisfied. Even exploitation has to face questions of sustainability and repeatability.

 

With safety nets and social welfare come a slowing of productivity simply because people become less adaptable, less driven, less hungry. Short term gains derive from the stability that social welfare provides in the form of the ability to plan further and to invest in skills and other labour empowering policies. Eventually, safety and security are the enemies of invention, adaptability and progress.

 

Even in the absence of social welfare an economy evolves and matures and slows. As an economy grows, the distribution of wealth and income grows. Societies can address this in two ways, social welfare, being the collective solution, or private saving. Where social welfare is absent, uncertainty and risk encourages private saving. Safety nets whether public and collective or private and individual lead to the same loss of adaptability and flexibility, loss of drive and a growing intransigence. Eventually economies face a suboptimal labour force.

 

A proper model of employment takes into account the unpleasantness of the job (including such considerations as physical risk, mental stress, prestige or lack thereof), and not just the wage or marginal factor price, but the wage in relation to the stock of wealth of the individual. This may explain why some jobs are undersupplied despite reasonable wages, and others are oversupplied despite relatively low wages.

The rescue efforts from 2008 – 2012 to bail out the global economy have resulted in a massive inflation of sovereign balance sheets almost everywhere from the US Fed, to the Bank of England, the Bank of Japan, the Peoples Bank of China, and even the ECB.

Central banks have become some of the largest buyers of their own countries’ debt issues. Holdings of US treasuries have surged not only at the US fed but by the US private commercial banks as well. Regulations such as Basel 3 encourage banks to purchase assets which do not consume capital (as assets risk weighted zero under Basel 3 are treated.) High grade sovereign bonds are risk weighted zero and even dodgy sovereign bonds face a lower risk weight than better quality SME loans. The result is a buying frenzy of government bonds.

 

There are two reasons a country would seek to buy its own bonds, whether directly through its central bank, or indirectly through its state pensions or private commercial banks. One is to increase the money supply in the hope of boosting nominal output growth, in the further hope of generating real output growth. Two is to compensate for any shortfall in demand for the country’s bonds, that is to act as lender of last resort to oneself.

 

Chart: Fed System Balance Sheet:

 

 

 

M.dV + dM.V = P.dQ+dP.Q is the relationship between money supply, velocity of money, inflation and real output.

 

Since 2008, the efforts of central banks to increase the right hand side of this equation, that is nominal output, has seen a drastic increase in the money base and the assets of the banking system. Central banks have levered their banking systems between 3 to 5 times over. Unfortunately for both real and nominal output, the velocity of money has simply compensated for the increase in the money base so that nominal output growth has been tepid. A proxy for the velocity of money is the money multiplier.

 

Chart: Money Multiplier:

 

 

 

 

For an economy not at full employment, the hope is that real output rises instead of prices. Apparently the global economy is not at full employment. The risk of inflation is thus low. This analysis does not take into account some psychology.

 

Given how widespread money printing is globally, and given the scale of the monetary expansion, consumers and investors would be reasonably expected to be concerned about how this policy can be retracted once full employment is restored. Further, given that money printing debases its value in real terms purely as a store of value, one may reasonably be concerned about the inflationary impact of protracted and continued debt monetization. In addition, at least thus far, quantitative easing has been seen as a part of expansionary monetary policy and not as debt monetization from an excess supply of debt perspective. Any loss of confidence may lead inflation expectations to rise. Even a real recovery might boost inflation expectations. In itself, inflation expectations can be benign but in the context of the scale of leverage in the banking and sovereign debt system, inflation expectations demand answers to difficult questions: how will financial system wide balance sheet leverage be reduced when full employment or inflation threatens?

 

The world’s economies and markets are all acutel
y dependent on low interest rates. If central banks were forced to withdraw liquidity, a way would have to be found which would keep rates suppressed, an almost contradictory condition. Selling bonds would be highly risky given the impact on interest rates. The borrowing requirements also suggest that the treasury will need to refinance itself well into the future.

 

The 30 year bull market in bonds, the agency issues with central bank ‘puts’, have brought us deep into a game of chicken played on a suspension bridge. Its not clear how long we can carry on, but neither can we flinch.

Given the fragile state of the global economy the resilience of risky assets is remarkable.

Year to date, the MSCI World index is up 8.0%, bonds are up 11.7%, high yield has gained 8.3%, emerging markets bonds 12.3% , emerging markets equities a paltry 3.2% and crude 7.9%.

 

Volatility and risk in developed markets has risen relative to emerging markets. A rational strategy therefore is to buy straddles on developed markets’ businesses while selling straddles on emerging markets’ businesses. Here we refer not to equities but to the underlying assets and cash flows of the businesses. Thus, buying a straddle would involve buying both a call and a put option on a company’s assets. This is equivalent to buying the equity stock and selling short its corresponding bond. Put together the whole trade broadly looks like: long (or overweight) developed market equities and short (or underweight) emerging market equity; long (or overweight) emerging market bonds and short (or underweight) developed market bonds.

 

Apart from the real options theory basis for the trade there is a more intuitive justification. Emerging markets growth rates continue to outpace develop markets (despite the current synchronized slowdown). Yet corporate governance and rule of law remain underdeveloped in emerging markets, at a protectionist and mercantilist time in global economics. It is safer to access emerging market growth through developed market companies deriving revenues from emerging markets, or through foreign listings. As Europe slumps and the US remains under very muted growth, the export heavy listed markets of the developing world are more likely to suffer. If one feels compelled to buy emerging market companies for whatever reason, the seniority of claim of bonds is a safer trade expression.