CNBC European Business | Safe Haven Or Slippery Slope?

Safe haven or slippery slope?

With the credit crunch continuing to decimate the banking sector,  where next for the high-net-worth individual’s money? Chris Owen reports

It is a measure of the shocks that have reverberated from  Wall Street’s implosion that Merrill Lynch, an aristocrat of the wealth management firmament and ranked third globally with $1,309bn of assets under management in 2007, slid into the distinctly blue-collar embrace of Bank of America in September at a knockdown price of $50bn.

None of the big name brands have escaped entirely unscathed from the heavy subprime write-downs and the credit crunch, as a glance at the top 10 in this year’s Private Banking KPI Benchmark survey by wealth consultancy Scorpio Partnership reveals – UBS, Citi, Merrill Lynch, Credit Suisse, JP Morgan, Morgan Stanley, HSBC, Deutsche Bank, Wachovia and BNP Paribas. Many were hit hard with multibillion-dollar write-downs and the collapse of confidence and consequent rash of consolidation in the third quarter will have a huge impact on the rankings for 2008. 

Swiss bank UBS, last year’s market leader, posted its first-ever full-year loss, followed by two successive quarters of losses this year, as it had to write down over €31bn worth of subprime-related assets. At the same time it has suffered considerable reputational damage from high-profile legal cases, such as a United States investigation into whether it assisted its US clients to evade taxes. 

It is too early to say what impact all this will have on the key industry benchmark, flows of net new money. UBS, for instance, recorded net outflows of €6bn in its Wealth Management International & Switzerland division and a net outflow of €5.1bn in Wealth Management US during the second quarter but, to put it in perspective, this represents less than 1% of total assets under management. 

Much more revealing will be the figures for the third and fourth quarters across the industry, which will show whether such flows were sustained, or accelerated, as the financial crisis bit – and where the money is heading. Reason and logic would suggest that the main beneficiaries will be either those integrated banking groups that have not been tainted by subprime or the pure-play private banks. 

This redistribution between types of banks was already evident in 2007, when a number of smaller, independent banks experienced very strong net inflows. Pictet & Cie, Switzerland’s largest closely held private bank, boosted assets under management 30% last year to $120bn last year, while Bank Sarasin, which is controlled by Rabobank Groep, had a 21% increase in assets to $40bn. 

In recent years, the pure private-banking model was deemed to be at a disadvantage to the integrated banking model, in terms of the flexibility, distribution and investment opportunities that it could deliver to high-net-worth individuals (HNWIs). But in more uncertain times, it may be that this is the model HNWIs feel safest using and their net inflows will spike dramatically. 

“There is an impetus to move to smaller banks where lending is not a primary concern, where there is little exposure to property, and where the partners are invested alongside clients which provides private clients with more reassurance,” says Catherine Tillotson, managing partner at Scorpio Partnership. 

The picture may be further distorted by deposit protection arbitrage as governments come under increasing pressure to shore up confidence in banks. Billions of pounds left UK banks in October when the Irish government moved to guarantee all customers’ money deposited in Irish banks. At the same time Northern Rock, nationalised in February after the first run on a British bank in more than a century, was forced to close its leading products to new savers after a surge of deposits, attracted by its government guarantee, put it close to breaking competition rules. 

This may be less of an issue for HNWIs because protection schemes only cover cash on deposit and their limits do not necessarily represent a high floor. For HNWIs diversity is the key. They might have accounts with several institutions worldwide, so they don’t have all their eggs in one basket. 

The need for a safe haven in troubled times is equally true for asset allocation strategies. According to the 2008 World Wealth Report, published by Merrill Lynch and Capgemini, the early months of 2007 showed HNWIs betting heavily on riskier asset classes. But as the year wore on, and financial market turmoil and economic uncertainty intensified,  HNWIs began to retrench, shifting their investments to safer, less-volatile asset classes. 

The report found that cash/deposits and fixed income securities accounted for 44% of HNWI financial assets, up nine percentage points from 2006. Fixed income securities saw a six-percentage-point increase in asset allocation, accounting for 27% of holdings, up from 21% in 2006. Globally, HNWIs continued to decrease their holdings in North America and showed greater interest in domestic market investments, preferring more familiar ground amid economic uncertainty. 

“We are seeing extremes of behaviour in terms of moves into cash and gold, but most wealth managers are advising clients to sit and hold,” says Tillotson. “The stocks affected by subprime and the credit crunch have been primarily financial and property-related thus far, so a well-diversified portfolio should not be falling through the floor. There has also been a big globalisation of portfolios over the last decade – the trend for fund-based investing in particular has given greater access to international markets – and this should help to support returns. 

“HNWIs are also seeing opportunities in private equity deals that would not normally cross their desks because private equity players do not have access to leverage at the moment, which limits what they can do. Hedge funds, despite their successes and failures, will still be attractive because there is a big demand for non-correlated assets. The same for commodities. Structured products will still have a place in the portfolio but they will need more transparency. Private clients will want to know who is underwriting them and who the counterparties are.” 

And how is it best to advise clients in the midst of a crisis? “As frequently as possible,” says Tillotson. “Wealth managers should be trying to speak to all their clients, especially those banks that are being forcibly merged. Clients want to be kept informed and front-line staff should be fully briefed. It won’t just be a matter of giving the house view but responding to specific concerns with conviction. For now it is crisis management – they must have something sensible to say to clients who ask ‘what does this mean for me’? And, when the dust settles, they must have a coherent strategy in place.” 

Even more delicate is the need to justify fees when investment returns are negative. The key here is to be outperforming the core indices. “Wealth managers almost always talk about performance in respect of a benchmark, particularly in down markets,” says Tillotson. “There has been debate in recent years about wealth managers moving to performance-related fees but, perversely, the current market probably favours traditional asset-based fee structures because clients will be wary of incentivising their wealth manager to take silly risks. As Warren Buffet has noted, in the investment business you get paid as much for stepping over a one-foot bar as you do for jumping over a seven-foot bar.” 

What is certain is that wealth managers are operating in an extremely competitive arena at a time when private clients and their assets are likely to be at their most volatile and capricious. The US market, in particular, has been ravaged and is set to suffer great convulsions. According to a survey from US private wealth market researcher Prince & Associates, 81% of investors with $1m or more in investible assets plan to take money away from their current advisor and the irritation is especially high at the “brand” firms. There is much to play for.