Handling high-net-worth clients

High-net-worth clients are different. Their expectations are high. They’re not easily impressed. And they don’t go for canned solutions. So, what’s an advisor to do? Start by understanding the segment.

Who are the wealthy?

Definitions of high net worth vary widely. One client, who springs from humbler beginnings, may feel quite wealthy with $300,000 in investable assets, while others with $2 million might consider themselves middle class.

Within the industry, the threshold is certainly set higher than $300,000. It’s generally agreed that anyone with $1 million to invest should be considered wealthy. But the differences between a high-net-worth client and the mass affluent are really only a matter of degrees, according to Greg Bieber, first vice-president with Richardson GMP in Winnipeg.

“They’re wired front to back the same as you and I,” says Bieber. “Middle class or high-net-worth, it’s the same thing: they want to keep their money.”

In both cases, the clients have engaged their advisors to simplify their lives. They realize they don’t have the acumen to manage their finances and investing. And in the case of the HNW client, the risks are far greater. If there’s one real difference between the wealthy and the mass affluent, it’s in their risk appetites, with the HNW clients generally being far more conservative.

“The wealthy are certainly not asking for 20% returns. People who have less money, that’s what they like to do,” says Bieber. “The wealthy don’t like to gamble; that’s why they’re wealthy. They want to keep what they’ve got.”

The wealthy also don’t like flash, so many advisors serving high-net-worth clients develop practices that reflect such preferences.

Bieber describes his investment counsel as timeless and it’s hard to argue with his classification. He builds his clients a professionally managed, diversified portfolio. The strategy is to buy and hold—and the hold period is forever. The goal is to generate an income stream that the client can live off of without touching the principal. And that forms the basis of wealth for the next generation.

Generally, changes in the portfolio are only made when a manager strays from what the client was expecting. Deviation from their stated style can result in surprises on the upside as well as the downside, and clients need to understand excess positive returns are a sign of danger ahead.

“If I go to a client and say we’re going to make a change and they start giving me grief, that’s not a client, that’s an account,” says Bieber. “Accounts are rented; clients are lifelong relationships. And the ones that say they want more, they’re not clients, they’re just accounts.”

At the outset of client relationships, Bieber explains the portfolio will fluctuate, mapping out a range they might reasonably expect, based on their risk profiles. An initial investment of $5 million could drop to $3.5 million, or rise to $7 million, for example. “If the portfolio exceeds the extremes of the highs and the lows, then something is structurally wrong with the portfolio,” he says. “If the market goes up 50%, and their portfolio goes up 70%, there’s a bet in there somewhere.”

Tom McCullough, president and CEO of Toronto’s Northwoods Family Office agrees the wealthy are not prepared to roll the dice with their portfolio.

“We’re in the business of hitting singles for clients. That’s the way they want to live,” he explains. “They’ve made their money; they don’t want to do it again. They’ll never have another opportunity to build another business and sell it, so they do not want to lose it and they want a decent return.”

Clients will occasionally bring in their own investment ideas, usually asking if they should add a manager who has recently posted above-average returns. McCullough will discuss the pros and cons of that particular portfolio change to determine how it would fit into the client’s stated objectives. In the end, his clients usually agree that chasing 40% returns is far too risky.

His clients have a minimum family net worth of at least $10 million, often earned by having developed a family business. Many of his entrepreneur clients may be accustomed to taking risk, but he still counsels caution.

“What we say to them is: being undiversified and focused in one business was a great way to make money, but it’s not a great way to keep money. That’s where you need to be diversified.”

Building process

McCullough’s portfolios are very conservative, with the asset mix determined by an exhaustive engagement interview, which determines the short-term needs of the family, as well as the long-term goals.

“There are really only two things you can do with money: you can spend it, or you can give it away,” he says. “Saving it, investing it, leveraging it—it’s just an interim step to giving it away.”

Based on his initial discovery process, McCullough matches assets to liabilities. He divides client liabilities into two categories: the money they will need during their lifetimes, and their legacies.

Lifetime liabilities are funded with assets that are “very, very cautiously” invested in traditional and real-return bonds, as well as some dividend-paying stocks. “Their job is to not go down,” McCullough tells clients. “Their job is to totally immunize your living expenses for your whole life.”

Legacy money—which is being left to the next generation or to an endowment—can be invested less conservatively. This money may remain invested in the family business or more growth-oriented securities.

“That’s how the wealthy are different. There’s likely to be money left over, they aren’t just saving for retirement,” McCullough says.

And that’s not the only difference. Conventional wisdom holds HNW clients will not accept the same investment products as middle-class clients.

Proper funding

Josée Dumas, investment counsellor at RBC Phillips, Hager & North Investment Counsel in Quebec City, says many of her clients reached her $1 million account minimum by investing in mutual funds, but are now looking for more sophisticated options.

“Once they reach our service, they are attracted by the fact that they can be the direct owner of a stock or a bond, without having to diminish the quality of the diversification,” she explains. “On the tax management side, it’s more flexible when you own the securities directly. You can choose two or three stocks to be sold from the portfolio, and personalize the portfolio management with many details.”

She points out there are limitations to holding securities, as a properly diversified global portfolio would require a much larger account than a portfolio focused strictly on Canadian stocks. A domestic portfolio could be constructed with as little as $200,000, she says, but this would be far too little capital for a global portfolio. To gain international exposure, pooled funds or exchange traded funds may complement a portfolio of direct Canadian holdings.

McCullough uses segregated portfolios for virtually all of his clients, with third-party money managers investing client assets directly into individual securities. The closest his client’s assets come to a mutual fund is a pooled fund or an ETF.

“We would never buy mutual funds; they are just way too expensive. Never, ever, ever,” he says. “There’s absolutely no reason for a wealthy family to buy a mutual fund, with the fees that are charged on them and the history of non-outperformance.”

Since his clients have a minimum net worth of $10 million, even the emerging markets portion of a portfolio would be invested directly, although they could consider using an ETF to get that exposure.

“To look after the $2 million-plus clients, I think you probably figure out pretty quickly that 2% fees on mutual fund investments are a bad idea,” he says.

Bieber’s also a proponent of separately managed accounts, but is more open to mutual funds. For his clients, the most important consideration is that they no longer have to worry about their money.

“I counsel professionally managed money, and it can come in the form of mutual funds, or third-party managers,” he explains. “The bottom line is the client isn’t managing it; someone who is a professional is.

“We’re selling clients a diversified portfolio; mutual funds just happen to be one particular tool to get there.”

The million-dollar threshold does tend to split clients into two camps—those invested in mutual funds and those with third-party managers. Due to the minimums attached to the third-party managers, investing less than $1 million limits the number of managers the client can hold.

But even for clients above the million-dollar hurdle, he says there are tax-planning reasons to use mutual funds, rather than direct holdings.

“If a client had $5 million and I didn’t want to subject them to U.S. Estate Tax by buying them U.S. situs assets in their separately managed account, then I would get them a U.S. mutual fund,” he explains. That liability could be covered with insurance, but sometimes the mutual fund option is more attractive.

“I’m sure there are lots of people in this country who own U.S. direct assets—individual stocks or professionally managed assets—in their portfolios, and not realize they are going to be subject to a U.S. Estate Tax bill. I would use mutual funds because they are a trust and wouldn’t be subject to the tax.”

Hedge funds

For most of Canada’s wealthy, tradition seems to reign. Stocks and bonds are the preferred investment choices. The alternative investment market is alive and well, but for HNW clients, it manifests in only the most traditional ways.

“Wealthy people do want to feel like they have a bit of an edge, so they will venture out and get real estate products, hedge funds and different styles of money managers,” says Bieber. “But not at the expense of their base, which is cash, bonds, and professionally managed pure equities.

“Hedge funds are more for the higher-net-worth clients—not the $1 million accounts, but the $5 million-plus accounts—although I sense the hedge fund industry is trying to reach down to a wider consumer base.”

While hedge funds are popular south of the border, they see little use in Canada. In 2008, McCullough estimates between 20% to 50% of American family office portfolios invested in hedge funds—“all sorts of things that you couldn’t explain to your grandmother or even your financial advisor.” That was not the case in Canada, where portfolios have always been more traditional.

McCullough says there’s probably some truth to the stereotype that Canadians are simply more conservative than American investors. The mid-2000s were a golden age for hedge funds in the U.S. In Canada, income trusts were all the rage, until the federal government moved to limit that market’s growth.

“You want things that are understandable, that if you look through them with the client, we all get it; we know what they are, as opposed to some kind of complex thing that people got in real trouble with, because they didn’t know what it was,” McCullough says. “We don’t do a lot of that kind of esoteric stuff.”

The HNW attitude toward hedge funds is mirrored by Canadian institutional investors, which he says have not embraced hedge funds to the same extent as their American counterparts. The reason is clear: investors want transparency.

“I can’t imagine who wouldn’t prefer transparency,” he says, pointing out the weakness of the black-box mentality prevalent in the hedge fund industry.

“The alternatives we are involved in are private equity and real estate. To us those are understandable, you actually own a piece of land or a piece of a company, something you can point to, not some trading strategy that may or may not work. And you’re locked into it.”

Still, the marketers would try, contacting him at least a dozen times a week with some new hedge fund or structured product fund, invariably with first and second quartile results.

“I guess no one is in the third or fourth quartile,” he quips.

Client protection

One challenge in serving the wealthy is that they’re frequently approached by outside promoters seeking financing for their latest project.

Inevitably, a brother-in-law—it seems it’s always a brother-in-law—will recommend an investment to the client, who will bring the matter to the advisor. Should they buy into this apartment block? I hear the market is going to crash again, should we get out now? Let’s put half my money into private mortgages.

“If it’s not a good idea, we will pull out their investment policy statement that they signed, and we’ll talk through the objectives and ask, ‘Where does this fit?’ ”

McCullough says. “If they had assigned 5% as fun money and this is a venture they want to put in there, then great. But if it’s a big thing and we can’t convince them not to do it, we will redo the policy statement and ask them to sign it with these changes.” He says the process of rewriting the IPS with a higher risk rating will often give the client second thoughts about the wisdom of the changes after all.

“A policy statement is written when you’re sober. But when you’re drunk with fear or greed, or being pushed by a friend, you need somebody to help you look back at what you wrote when you were sober, because you aren’t in any shape to make a rational decision.”

Still, there is a speculator that exists inside everyone, just waiting to express itself, Bieber says. The job of the advisor is to restrain that beast with rational arguments. “Where there’s a client, there’s an advisor; and the client listens to the advisor,” Bieber says. “Our job is to give the plain, unvarnished truth all the time, and let the chips fall where they may.”

He recalls one client who insisted that his brother-in-law had predicted the 2008 market decline and was therefore a better forecaster than Bieber. The advisor walked the client through his investment policy statement to no avail; the client wanted him to move his assets based on the brother-in-law’s recommendation, even though he had never actually met him. Bieber asked the client to sign a letter stating he knew what he was doing, and resigned as his advisor. A note was attached to the account file that he would not accept the client if he returned.

Such outcomes aren’t pleasant. But they can be necessary. Sometimes a little upfront research can reduce the likelihood of an advisor having to fire a client.

“The one piece of advice that I would give to anyone wanting to focus on the wealthy is to spend a lot more time on the upfront discovery process,” says McCullough. “Ask ‘why?’ ten times and I think you’ll get to a better answer, rather than too quickly getting to a product.”