In the second part of this feature on "hyper-diversification," Angelo Robles, founder and chief executive of the Family Office Association, discusses segregation and jurisdiction risk. The first part, which looks at ownership and margin risk, can be viewed here.

The information is for educational purposes only and is not legal/tax/financial advice. The views within are the author’s but this publication is grateful for the right to share them.

Segregation risk

Banks and wirehouses are, by law, supposed to segregate clients’ funds from their own. Regulators such as the Securities and Exchange Commission and Chicago Mercantile Exchange are supposed to provide oversight to ensure that financial firms are not commingling their assets with customers’ cash. However, some financial institutions have been thought to temporarily dip into client funds. While this practice is claimed to go unnoticed and segregation is reclaimed in the clients’ account within 30 days, one deal gone bad could put billions of dollars at risk.

This is precisely what happened in October 2011 with futures clearing firm MF Global. Its CEO, Jon Corzine, invested $6.3 billion in risky European sovereign debt, which caught the eye of worried credit agencies and trading partners.

This lack of confidence led to a liquidity squeeze that sent MF Global into bankruptcy. Bankruptcy proceedings revealed that the company had commingled its investments with clients’ funds, which created a $600 million shortfall in customer money. As a result, customers’ funds were frozen. It is not clear whether they will ever fully recover their money.

Investors with Bernie Madoff suffered from similar problems when he failed to segregate different clients’ funds. Many of them never recovered financially.

Human error, not just greed, can expose investors to segregated funds, as in the more recent case of Cantor Fitzgerald & Co, Inc., which was fined $700,000 by the US Commodity Futures Trading Commission in November 2012 for failing to maintain adequate segregated customer funds for three days earlier that year, when Cantor’s employee in charge of running daily computations (to determine the amount of customer funds it needed to be on deposit to meet its segregation requirements) was out sick.

We now are starting to hear terms such as “under-segregation,” and claims of firms having temporary breaches in segregation requirements - as though segregation were anything but black and white.

There is no way to know if one’s financial institutions maintain complete segregation, but wealthy investors can, at least, spread out the risk by diversifying. 

Becoming a global citizen

Diversification requires much more than investing in different asset classes. Full diversification also means spreading assets among several advisory groups within each institution, in multiple institutions, in each jurisdiction and, in turn, in each of the national jurisdiction’s currencies.

• Geographic and currency diversification. Because the US has the biggest and most liquid capital market, holds reserve currency status and has the largest monetary float in the world, the intellectual challenge is to determine and know what to leave at hand within the continental US and in US dollars and as a result, what to diversify abroad.

At the moment, safe locations - jurisdictions with stable capital markets - include Singapore, Australia, Canada, Norway, the US, Brazil, England and Switzerland. Of these, Canada, Brazil, Norway and Australia are all resource rich countries with mostly non-US export-dependent economies.

However, it’s important to closely monitor developments in the countries where assets are held, to make sure those locations remain safe and strategically suitable for each family office - in line with each investment policy guideline document.

A family with $1 billion in net worth may want to keep $250 million in at least three institutions in the US, and an equal diversified amount held in Canada, Singapore, Switzerland or Australia. If, however, the family feels a particularly high level of trust and patriotism, they may want to keep a greater portion in their country of origin.

• Institutional diversification. Funds in each country should be in two or three institutions. Therefore, the family’s $250 million in Canada could be split between, for instance, two large banks and a smaller firm.

In each bank, the family should maintain a commercial account, a safe deposit box, precious metal bullion, multiple currencies and cash in the respective local currency, and a multi-advisor wealth management relationship. It even may be wise to purchase US Treasury securities from those foreign institutions.

• Advisor diversification. No one financial advisor in any bank can claim expertise in all asset classes. Therefore, within each institution, it’s important to maintain a strong relationship with a trusted advisory group that will act as the family office advisor within each institution, as a fund-of-fund advisor using internal knowledge and relationships to deliver best-in-class advisory groups.

The advisory groups should divide money among five to seven advisory group (managers) who are each best-in-class for one type of investment, such as: municipal bonds, corporate bonds, private equity, SMAs, precious metal bullion and wealth preservation strategies.

The idea is to keep a top-down relationship for control and flexibility while also maintaining exposure to specialists in each asset at the different advisory groups. This will enable the family to maintain a non-correlated portfolio to what the others are doing (one financial advisory group relationship, many advisory groups under that one). That means the municipal bond advisor at, say, Morgan Stanley, may be a rock star in short-term securities, while the muni trader at JP Morgan may have a special strength in medium-term munis, and the Merrill Lynch muni person may specialize in long-terms.

• Asset-class diversification. Even many inexperienced investors know it’s crucial to make sure their asset mixes remain within fixed parameters based on their risk profile.

Because the financial system itself has been strained to the max by the events of 2008, and is vulnerable to political turmoil, computer viruses and hacking and various acts of nature, it is more important than ever to beef up holdings in real assets such as gold and silver bullion (coins, bars, certificates), jewelry and art. As previously mentioned, it’s important to keep these holdings in diversified locations, institutions and jurisdictions.

One good example to consider is the Australian mint, for allocated ownership of bullion and certificates (with AAA rating and insured).

To maintain even more airtight control, families will want to invite their advisory teams within each bank to a meeting, to discuss their current outlook and approach. It will keep everyone on their toes and motivate them to work as hard as possible to compete with each other while maintaining a non-correlated investment strategy.

These multiple dimensions of hyper-diversification can be at times a challenge for family office CIOs, but this is what is best for the family. Protecting their fortune from the vagaries of the market and from problems with any one country and its currency, institution, advisor or asset requires a tremendous amount of vigilance from bottom up, with an overview of top-down control.

Unfortunate investors who had their money at MF Global or Lehman in recent years are still trying to recover hundreds of million dollars in capital. Those, however, who had distributed their capital among various advisory teams, multiple institutions, several countries and non-traditional assets holdings, would have been less exposed, resulting in a fraction of the losses as they were properly protected.