The letter would read something like this: ‘Dear Mr Smith, I am pleased to inform you that as a result of our strong stock selection process your portfolio has outperformed the index by 3.5 percentage points this year.
‘Unfortunately, shares have been in a severe bear market since I last wrote to you and as a result your portfolio has fallen in value by 25 per cent.’
There is only one problem with this missive: you cannot eat relative performance; only absolute returns let you sleep soundly at night. Not surprisingly, the bear market that began in 2000 and ended after shares had halved in value, has produced a revolution in the expectations that wealthy families have of fund managers.
People who used the discretionary portfolio services of traditional stockbrokers have typically had the worst wake-up calls. Having been lulled into a false sense of security during the long 1990s bull market and having placed a growing proportion of their assets in increasingly expensive equities, they had nowhere to hide when the bubble burst.
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And the pain felt even worse when they found themselves sitting at dinner next to some cheerful fellow who had been clever enough – or sufficiently well-advised – to buy hedge funds – those new-fangled investment products that claimed to make money out of falling as well as rising markets, aiming to beat returns on cash, not chase the volatile movements of an equity index.
The fact was that the old stockbroking model was broken by 2003, smashed by the worst bear market since the 1970s. Looking back, it is plain to see how intellectually threadbare such an approach was.
Why, for example, should private-client stockbrokers, with all their responsibilities for marketing and client service, beat the full-time asset managers focussed 24/7 on their funds? And how, if they played safe by sticking to the big stocks in the main indices, were they benefiting their clients by loading them up with Marconi and Vodafone?
This might enable them to hug a benchmark but it was hardly providing clients with diversification, with the top twenty stocks accounting for almost 60 per cent of the market in 2002.
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There had to be a better way and many wealthy families now demand more sophistication from money managers, wishing them to blend traditional – even old-fashioned – judgement with more modern portfolio management techniques.
The starting point is renewed interest in ‘absolute returns’. The old private-client fund management adage was that clients were relative on the way up and absolute on the way down – they wanted outperformance of the index in the good times but capital preservation when times were tough.
Today, people recognise they should aim for greater stability and more predictable returns, with capital preservation in diverse market conditions – doing better than cash – being the starting-point and minimum objective in any investment strategy. After seeing their holdings tumble during the dotcom crash, they wish to avoid being sucked into future bubbles.
In theory, this could be achieved through market-timing but an investment process revolving around trading in and out of markets at the right times is pregnant with difficulties. Take the 1990s, when US equities showed annualised gains of 18.9 per cent.
If, however, an investor was out of the market for the best ten trading days of that decade, the annualised return falls to 10.9 per cent. Out of the market for the best twenty days and the return drops to 7.9 per cent; out of the market for the best 40 days – less than two per cent of all trading days over the decade – and the return drops to just 3.2 per cent.
There is, however, a more practical approach involving four key priorities. The first is access to the best asset managers – the guys and girls who have honed their investment processes over many years and have proven records of long-term outperformance.
They are the alpha males and alpha females of the industry – and they are not typically found buried in large institutions, following some committee-driven, lowest-common-denominator institutional process.
Instead, they tend, for two reasons, to be found in independent investment boutiques. First, boutiques hold them accountable but also give them freedom to perform, subject to monitoring and compliance.
Secondly, the incentives suit them: they receive significant rewards for achievement – they will, as alpha beasts in the investment jungle, eat some of what they kill.
Some boutiques have profit pools; others give staff restricted equity, tying them in with golden handcuffs that ensure their interests are aligned with the long-term interests of clients. In addition, boutiques often insist their asset managers invest in their own savings alongside their clients – and there is no better way of focusing the mind on generating long-term absolute returns than having one’s own balance sheet at stake.
Some of the brightest and best manage hedge funds, either independently or within larger organisations, because they then share in the performance fees paid from the capital gains they make.
The second priority is having a seat at the top table. One reason is cost. A do-it-yourself approach to fund selection is possible, but all but the wealthiest families do not have institutional buying power, which counts in negotiating fees.
Another reason for having a top-table seat is that a client can access the fund-seeding opportunities simply not available to the man in the street. Such opportunities are attractive because younger, smaller funds run by talented managers do better than older, larger ones – it is easier to manoeuvre a frigate than an aircraft carrier.
The third priority is cultivating a proper respect for risk. In the heady late-1990s bull run, people forgot that risk and reward were two sides of the same coin. Chastened by their experiences, wealthy families should now insist their fund managers use the latest qualitative and quantitative techniques to temper the risks being taken with their assets.
They should be more open to the idea that their investment eggs be spread among different asset baskets with different risk-and-return characteristics. At the low-risk end of the spectrum, they need cash, bonds and commercial property. In the middle, they need hedge funds focused on beating cash but with less volatility than equities.
At the high-risk end, they need traditional equity funds and commodity funds, and at the opaque outer fringe they need private equity.
Even within a single asset class such as equities, sophisticated investors will want their money managed by people who generate returns from different parts of the market. They might wish to blend those who buy lowly-valued big companies with those who try to buy the small fast-growth companies that may become tomorrow’s giants or be gobbled up by today’s giants at a hefty premium.
The result, if the private-client fund manager mixes the cocktail correctly, is a stream of healthy long-term returns delivered with lower volatility along the way. The last priority is to be on ‘bubble’ watch, as it is easy for money managers to become intoxicated by a mature bull market’s heady aroma.
The shrewdest people recognise the wisdom of the first Lord Rothschild. When asked for the secret of wealth creation, he simply said that it was ‘selling too soon’.
