Until very recently, high net worth individuals have maintained large allocations to cash but such holdings present their own risks and challenges.

Cash now has recently accounted for a historically high chunk of portfolios as high net worth individuals have spurned complex, or risky products.

However, this increased cash weighting is having a detrimental effect on both clients’ returns and firms’ revenues. So it is worth asking what firms are doing to encourage clients out of cash.

There has been a massive shift towards cash and cash equivalents such as government bonds and US treasuries in the last two years ago, according to Phil Cutts, who is head of advisory at RBC Wealth Management.

“Clients are getting into ultra safe and cautious vehicles at the expense of return,” he said.

Merrill Lynch and Cap Gemini’s 2009 World Wealth Report found that HNW individuals reduced exposure to equities and alternative investments in 2008 and their cash based holdings rose to an average of 21 per cent of overall portfolios - up 7 per cent from pre-crisis levels in 2006.

HNWIs were “happy to settle for a return of, not on, their capital”, according to the report, which cited investors buying zero-yield US Treasury bills in the second half of 2008 as proof of this.

The authors of the World Wealth Report do not see a quick reversal of this trend, predicting that by 2010, allocations to cash and fixed income will remain at today’s historically high 50 per cent level.

There are two impacts of asset allocations being so overweight cash. In the first instance, a focus on safety comes at the expense of returns, making the prospect of recovery slower for those clients that remain in cash and other low-risk assets. Secondly, clients’ risk aversion is arguably affecting firms as sharply as clients. PricewaterhouseCooper’s recent private banking survey noted that as clients move into cash and less risky instruments this has meant lower margins for wealth managers.

Darrel Poletyllo, director, of wealth advisory at PricewaterhouseCoopers, has seen the reduction in appetite for asset backed investments such as stocks and bonds, affect advisers and the firms where they work.

“While most advisors and managers will take a margin from cash, it is typically significantly lower, which has a knock on effect to profitability,” he said.

Margin squeeze

Fixed income and cash have generally been far less remunerative for banks than higher risk asset classes. The Merrill Lynch;/Capgemini  estimates that firms achieve a margin of 31.4 basis points on fixed income, whereas a typical commission on equities would be closer to 100 bps and much higher for some complex structured products.

Scorpio Partnership’s 2009 Private Banking Benchmark found that those with the highest gross margins in 2008 were private banks with strong deposit and lending capabilities. However, as many private banks do not lend, they were unable to take advantage of the cash inflows to bolster revenues as spreads widened to end clients while spreads in wholesale money markets tightened. Scorpio did, however, note that even for those firms that were more successful in this regard, banking revenue would not sustain a costly infrastructure for long.

Private banking profits declined by an average 32.9 per cent in 2008. Scorpio’s Graham Harvey said that despite falling asset values and a focus on safety, recent first half results for 2009 for many wealth management type firms have not been as bad as many expected, particularly for pure play banks and those with brokerage arms.

“This is largely due to trading activity as clients have switched from higher to lower risk investments,” said Mr Harvey. “The next six months will be the litmus test as to whether firms can persuade clients back into risk assets to achieve better margins.”

Firm’s persuading clients back into riskier assets isn’t simply self serving. The steepest decline in portfolio values was suffered by those HNWIs with the most aggressive asset allocations. It is therefore more aggressive investments that tend to deliver greater than average returns when markets recover.

“Private investors tend to buy at the top and get out at the bottom and this has been exacerbated by the financial crisis. Remaining out of the market is not an effective strategy for recovery. The market has rallied and the large numbers that are not invested have not benefited,” said PwC’s Mr Poletyllo, who also notes that when these investors do start to buy equities, it might prop up prices and make the rally more sustainable.

Inflation danger

He notes that a large number of investors are hoarding cash and whilst over the last 18 months, cash has been a worthwhile investment, it is important that investors do not track its performance down. “If investors are achieving around 3 per cent in cash, this is a real return and not doing too much harm. But if inflation does pick up, cash can very quickly depreciate in real terms,” he continued.

Firms employ various strategies to encourage clients out of cash and into the market, including increasing communication, developing alternative products and educational initiatives. The aim is to ensure that clients understand the implications of being in low risk assets and that by moving slightly along the risk curve, there are other products available that have some of the safety of cash, but with the potential for better returns.

Anecdotally, structured products have been the most popular modus operandi by firms to get clients back into equities. “There has certainly been a marked increase in the promotion of structured products over the last year or so,” said Mr Poletyllo. “The issue is how structured products are marketed as they are not a deposit replacement. In many instances, I can see the marketability, but not the desirability. Some structured products seem to be driven by what can be sold to investors rather than what is appropriate,” he said.  

Other cash alternative products firms are using to entice clients further along the risk spectrum include term deposits, money market funds, bonds and double currency units. However, it is vital that clients understand the relationship between risk and return.

“We talk to clients about what is available. It’s a question of understanding their risk appetite as well as their investment needs and working with clients to develop a portfolio that suits them. People want money for different reasons, whether for a legacy or to live on. You can’t generalise as there is a wide spectrum of risk appetites and some will not want to lose any principal, while others are happy to punt or gamble,” said RBC’s Mr Cutts.

Education

As firms earn more from risk assets, education of clients is key. Those firms that have developed a more sophisticated and detailed asset allocation modelling process and spend time going through this with clients may find that their clients are less inclined to revert to a less remunerative, lower-risk asset allocation particularly when markets are challenging.

“Those firms that conduct in-depth 'behavioural' risk assessments might fair better with keeping clients in risk assets,” said Scorpio’s Mr Harvey, although he believes that there is still not enough done at a systematic level to understand clients’ objectives around their wealth which is applied pre-portfolio construction.

Putting money into the market more slowly or ‘pound cost averaging’ is an important lesson to teach according to PwC’s Mr Poletyllo. “Investment theory is one thing, but human nature is another. Timing is not everything. Adopting a sensible, unemotional approach is,” he said.

Anecdotally, Scorpio Partnership believes clients are now moving along the risk spectrum with those who were in cash moving to fixed income and those who were in fixed income starting to get into equities. “They are putting feelers into market type investments, including hedge fund strategies and liquid plays. However, transparency and liquidity are still watchwords,” said Mr Harvey.

RBC Wealth Management says it also sees more risk appetite. “The comfort factor is returning. We are out of intensive care and the patient is recovering,” said Mr Cutts, but notes that a high proportion of assets remain in cash or near cash equivalents.

A recent Merrill Lynch poll of fund managers said cash holdings were starting to fall. After a period of hunkering down in the safety of cash, risk appetite may be on the way back. If this is true, it is likely to be good news for the wealth management industry’s margins.