How to meet clients' needs: Exploring the challenges facing wealth managers today

There are mainly two issues facing wealth managers today, each of which is potentially even more challenging than the EU Savings Tax Directive which came into effect last year.

The first concerns regulation, and revolves round the Gibraltar Financial Services Commission(GFSC) "Dealing with and Advising Clients" initiative as well as the forthcoming Directive from the EU: the Markets in Financial Instruments Directive (MIFID). These directly affect Gibraltar and are, or will be, followed in Gibraltar with greater influence on the way advice is provided by wealth managers.

The second issue concerns the clients themselves. Markets have been increasingly volatile in recent years: new asset classes have been introduced, including structured products and hedge funds, and world events since the millennium have had a significant effect on global political stability, and therefore on financial markets. How have these events affected portfolio risk and where do structured products and hedge funds fit within the asset mix?

As a matter of record,since December 1996 when Alan Greenspan,then Chairman of the Federal Reserve Board in Washington, spoke of "irrational exuberance" in equity markets, we had seen the UK

All Share Index rise by a further 65% in September 2000, after which it fell by 49%, bottoming out in March 2003, only to rebound by 91% at the end of March 2006. There is much evidence to suggest that this level of risk has been too rich for the blood of many investors. Similarly, as yields and inflation have reduced in the UK over the past ten years or so, relatively small movements in Interest rates now cause high volatility in bond markets, traditionally considered a relatively low-risk investment.

One of the key tenets of the Dealing with and Advising Clients initiative is to ensure that wealth managers have a clear understanding of their cli ents' needs and that there is a mutual understand ing of investment objectives. Thus clients' expec tations must be clearly understood, particularly their attitude to risk, ensuring that the investment products recommended are suitable for them. Other client requirements must also be ascertained: their need for income, liquidity, their expected returns, their aversion to certain types of investment, aversion to periods of loss, and the accessibility of their funds when they are needed. The written agreement between the wealth manager and client must be also be clear and unambiguous.

All of this means that,for wealth managers, there must be a clearly defined rubric differentiating whether they are product manufacturers looking for a market, or client-led wealth managers identifying and creating an asset mix to achieve the clients' identified goals. Furthermore, much has recently been said about "open architecture" but does this mean adopting a "supermarket" approach, whereby the financial institution is effectively a distributor for product manufacturers, or "guided architecture" in which external products are selected only when the institution has gaps within its own proprietary product range? In fact,"open architecture" means that products are sourced on a "Best of Breed" basis from the available market and used within the portfolio mix. SG Hambros is a firm believer in the "Best of Breed" approach.

The richer the palette of asset types and products, the more sophisticated the tools needed to build a portfolio that matches a client's expectations. The wealth manager has to be able to define and formulate a view about each asset class and instrument in terms of risk and return in order to be able to provide an optimised portfolio, i.e. a combination of assets that will, most efficiently, maximise the investment return at the client's agreed level of risk.

Professional wealth managers are, in general, well regulated, trained and qualified to advise their clients: however, much advice is intuitive, not well documented and without quantitative justifica tion for Individual investment products within the portfolio. Wealth Managers still talk of low, medium or high risk, measuring their performance against institutional benchmarks when what most clients really want to know is."What is the likelihood of me losing money, and. if I am taking a risk, what is the likely reward for doing so?" Many clients are really "absolute return investors", meaning that they judge performance relative to cash,and are averse to suffering losses in bear markets. Conversely, everyone wants to enjoy the benefits of bull markets, following the maxim of fear versus greed.

In order to provide the optimum environment for advising wealthy clients, we at SG Hambros have developed a process for identifying clients' needs and establishing a basis for agreeing a value of risk and a corresponding level of investment return. This is a software-based tool used by our private bankers and it comes in the form of a sophisticated questionnaire. Each question seeks to ascertain what a client's reaction would be to certain market events, some quite extreme but nonetheless pertinent given some market events over the past ten years or so. It also ascertains what our clients expect to secure as a long-term investment return and how much risk they are prepared to take in order to achieve this. For every investor, the return on cash or even cash plus 1% can be realistically achieved without taking a significant amount of risk. However, our process seeks to establish how much additional risk our clients are prepared to take, and how much more return they expect to receive on a medium-to-long term basis. This, of course, is a balance and a key part of the exercise to make clear the additional risk that realistically must be undertaken in order to achieve additional returns. Based on the answers we receive and the dialogue between our private bankers and their clients, we are then able to establish an equilibrium between risk and return against which we can construct a portfolio of suitable recommendations.

A well diversified portfolio may contain cash, equities, bonds, hedge funds, property, structured products, commodities and private equity-all of which have individual risk and return characteristics of their own. The exercise of diversification between decorrelated assets does much to reduce individual risk. The software tools we have developed enable our private bankers to optimise the use of each of these financial assets to maximise the level of Investment return for the level of risk agreed previously with the client. Our private bankers are therefore fully equipped with the means to perform this exercise for each of their clients. This means that all the investment products they recommend to their clients contribute individually to the overall financial objectives and the risk and return of the portfolio of assets held by the client. in order to do this, we at SG Hambros have evaluated each and every asset class and invest ment instrument and have developed a consistent approach to measuring risk, as well as a process for determining our own strategic long-term view of the annual return. Of course, it is impossible to predict long-term investment returns accurately, but a conservative view can be taken based on historical performance, our view of markets and the macro-economic environment. This allows us to benchmark our performance and also to overlay short-term views of markets on a tactical basis. for their employees," Fraser says.

In short,the process by which we, as private bankers, advise our clients is, first, to establish each client's financial objectives- what investment returns they expect and what risks they are prepared to take to meet these targets. Then, second, we use this to establish an equilibrium of risk and return taking into consideration income, liquidity and other factors. We then have the information necessary for determining suitable asset classes and optimising an appropriate strategic approach. This forms the basis of our relationship with all our clients. Having agreed all of this, our private bankers then have unrivalled access to well over three hundred investment products, all of which have been researched and selected from the available market on a fully "Best of Breed" basis.

"And, as Gibraltar's economy continues to grow this lack and the need for pension provision will become more relevant. Offering a good pension as part of the remu neration package is a way to retain "employees", he adds.

(In effect, a sound pension en courages employee loyalty particu larly in a commercial climate such as that of Gibraltar where firms compete to attract high calibre staff and management "head hunting" is not unknown.)

Like those administering funds, companies which DO provide pensions have a responsibility "to see that the funds respond to the needs of their members". They need frequent attention so that they measure up to changes in longevity, health care and so on, he adds.