Sat, 01/10/2005 - 22:00
According to one research report (published by marketresearch.com), high net worth individuals, at least In Europe, are classified as those with in excess of EUR 300,000 (USD 380,000) in liquid assets. Using that definition, the report suggests that the six major European economies (France, Germany, Italy, the Nordic Group, Spain and the UK) house some 648,000 high net worth individuals (at end-2002) with appropriate amounts of wealth onshore, and that their number has, since 1997, been growing at a compound rate of 7.9% pa. Of course this growth rate is an average - there is no doubt it was much higher in the first three years of the survey period than in the last three.
Also, there is no doubt that during the last six or seven years high net worth individuals, particularly in continental Europe and Asia - the US market is that much more mature - have been paying increasing attention to alternative investment products, seeing them as a means of achieving positive returns when shares were going south.
Starting with Managed Futures
This apparently reasonable expectation - that hedge funds should and can provide valid returns in otherwise difficult markets - is, at the same time, a boon and bane to hedge fund marketers in their dealings with high net worth individuals. For despite the fact that the wealthy were, as a group, core investors in the first widely available alternative investment products - the managed futures funds of the 1980s - their exclusive reason for being there, I would argue, was the unrealistic (long-term) hope of making good profits when the equity markets were going up and good profits when the equity markets were falling (there was no real discussion or interest in concepts of diversification, hedging, risk management and the like). In that regard, the exceptional returns achieved by many managed futures managers during the stock market crash of October 1987 were a marketing bonus of the first order.
For a while, up until the very early 1990s, managed futures funds seemed to be 'It'. But then in the choppy markets that preceded the great bull run of the mid and later 1990s returns began to fade and investors, particularly high net worth clients, began looking for the next best thing. Hedge funds commanded by star managers such as Soros, Robertson and Steinhart, were among the choices, as were a variety of emerging market plays. These were partially thrown out of line by the bond crisis of early 1994 and, more spectacularly, by the Asian contagion leading to the Russian collapse in late August, early September 1998.
Today, with an increasingly broad and sophisticated range of hedge funds available, the important question is whether high net worth individuals have become more discriminating in their selection of hedge funds, or whether they are, at the same time, still swayed by the dictates of financial fashion and the search for the 'philosopher's stone' of consistent, absolute outperformance.
Based on my experience running Platinum Capital Management (and my prior work with another hedge fund group), my answers to these questions are that many high net worth investors remain largely uniformed about the subtleties and likely outcomes (in different economic conditions) of the alternative investment strategies in which they invest. They become frustrated when the equity market goes up strongly and is lagged by hedge funds (as happened, by and large, in 2002) and equally they are unhappy if hedge funds fall when the equity markets fall (albeit far less severely).
These tensions are primarily the result of an absence of education but it would not be entirely fair to put all the blame on the alternative investment industry for this failure. In a number of jurisdictions, currently including the UK, the restrictions on providing financial advice - particular about offshore products - have, perhaps inadvertently, led to an information shortfall on alternative investments - despite the presence of good trade magazines and a series of websites. To correct this gap in education, may in the end require a change in regulations of the scale that occurred in Italy a couple of years ago and is taking place in Germany now.
Without a major educational effort, the high net worth investor could become, as far as hedge funds are concerned, a sort of financial fashion victim - tending to chase last year's numbers at the same time looking for next year's star manager but, above all of this, looking for a returns stream that is unlikely to be deliverable year-in, year-out as the economic cycle turns.
(To be fair, professional investment institutions are also susceptible to the demands of fashion and have been shown, from time to time, to abandon all pretence of undertaking lengthy and considered due diligence in a mad scramble to put money with the next great white hope).
New Marketing Requirements
Target Performance. That said, a number of things have changed and, in so doing, have tempered the marketing approach. In the early to mid-90s days of the macro economic stars (Soros et al), marketers and investors were blithely talking about annual returns in excess of 25% (Quantum achieved 27% pa over quite a long run). Nowadays target performance of above 20%pa would be viewed with some suspicion - although there are always statistical outliers. From a marketing perspective it is today better to promote an attainable target performance range because extravagant claims may also connote dangerous levels of risk.
Risk Disclosure. And risk is another important consideration but, sadly, I am doubtful about how many clients truly recognize the potential difference in the returns stream between a high volatility fund and a low volatility fund with similar performance targets. (That said, longer-term investors in managed futures funds certainly have, or should have, come to understand the concept of a high volatility investment from personal experience!). In any event, marketing teams have largely moved to promote expectations for durable risk-adjusted returns rather than unqualified performance.
Of course, risk is not just about volatility. Recent (European) studies have shown that the most likely current reason for a hedge fund failure is operational risk rather than poor or catastrophic performance. In fact as many as 50% of European hedge fund collapses in the last two years can be put down to weaknesses in the back-office, or equivalent, infrastructure. Despite this statistic, few indeed are the high net worth clients who look, in any detail into the commercial footing of a hedge fund group.
Reporting. Today's investors, including high net worth clients, require more regular and more detailed updates on performance than heretofore (although whether they read the material despatched is open to question). Gone are the days when a major-league stock picker like Julian Robertson could attract substantial investors into a fund, simply by the force of his reputation and then, as trading commenced only provide performance information on an annual basis. Today, monthly reports are the norm and certain funds are reporting weekly (although, to be fair, these are almost inevitably focused at the institutional sector).
One of the key questions which continues to perplex alternative investment product salespeople is whether the high net worth investor would really prefer an individually managed fund or a fund of funds. Without being able to put forward a definitive answer to this conundrum, I would certainly say that this is one of those issues that varies geographically.
My experience suggests that there is rather greater confidence in the skills of an individual manager - or, more likely, greater risk acceptance - in the USA than there is in Europe, and I believe the European market is more interested in funds of funds investments than a number of other financial zones despite the fact that regulators in, for example, Singapore, where Platinum has a series of funds registered, are much more lenient with funds of funds than they are with individually managed funds.
In the end, a group, such as Platinum Capital Management which is continuously broadening and strengthening its international reach, is obliged to offer, funds of funds, certain types of structured products and individually managed funds - covering all the bases.
The greatest current issue to confront the hedge fund salesman, particularly when dealing with high net worth clients is a new and sustained bull market in stocks. It is most unlikely that investors will rush to buy modest, if consistently, performing funds of funds when shares and long-only funds are booming. The response, which is starting now, must, as I said earlier, be more education. Those who recognize the importance of diversified alternative investment must increase the pressure on regulators to allow the investment public to understand the value of these products in terms of protection as well as performance.
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