Musing of a Bond girl 

#fixedincome
#ETF
#diversification
#discretionarymanagement 

June 2020

As the world continues to languish in Covid limbo and lament that half the year has slipped by, I am once again comforting some lucky few that time is always on their side.  My clients’ diversified bond funds and portfolios are earning coupons every day.  I used to tell clients these fixed income instruments, as long as they were diversified enough, would be the most reliable “employees “ they got.  As a rule, they work 360 days a year and take no planned or unplanned leave of any kind. Compare that to an average employee, who enjoys 17 days of public holidays if they are based in Hong Kong, and 10-20 days of annual leave, with additional medical, compassionate, marriage and maternity / paternity leave.  Diversified bond holdings yield 6-8% without leverage; my clients tell me their businesses can’t make 6-8% without bank loans.. needless to say those who invested with bank lending and traded the yield curve enjoyed much higher returns. 

For many years running I have also been able to conduct year-end account reviews around October and recycle the same analogy-if the client had been away and uncontactable in the South Pole since January, he would find the equity markets at roughly the same level in October as they were in January.  But the bond portfolios have made him 6-8% with no leverage.  The only thing he would have missed was the rollercoaster ride of the volatile equity markets.  The ageing population in Asia is always receptive to this risk averse approach, especially when equity markets performance happens to be too volatile or flat. 

Despite the drawdown in late Q1 especially among the perpetuals, most of the selling was in the HF space and HNW practically saw relatively little action.  Advisors across Asia report lots of interest to “wait and see” or “buy on dip.” If lots of investors conducted their Q4 2019 portfolio cleanup with discipline, they would definitely need to beef up their portfolios in Q1 2020.  It appeared the sell down fear of a small (highly-geared) population was well matched by the fear of insufficient income.  

Traditionally fixed income is the bread and butter of private banking and in Hong Kong (where most of the client base is in inherited wealth) fixed income still reigns.  While niche trading practices and glamorous club deals capture the attention and imagination of industry veterans and clients alike, it is the discretionary instruments that keep our elite going.  Dependable, if non-descript, bond holdings and funds are like a well-oiled machine providing “salary.”  Some trusts distribute an annual income to family members-consider this a universal basic income for the elite- you just cannot expect a manager entrusted with such a task to liquidate a significant portion of the portfolio for the allure of higher potential NAV implied (but not always delivered) by equities with higher risk return profile.  Making a suggestion to the gatekeeper to maintain higher cash holdings “when markets are bad” would earn zero brownie points as some of the beneficiaries are bound to object to the loss of income and / or erosion of capital. In the interest (no pun intended) of minimal dispute and minimal legal liability, all parties would vote for FI.

Wealth preservation has always been central to the traditional private banking business.  The ultimate goal of wealth preservation is smooth and successful wealth transfer. To that end industry professionals advocate discipline and diversification.  Discipline In essence means several things: determine investment parameters and follow the mandate religiously, avoid getting distracted by other exciting opportunities that are not suitable for this particular family / account / pot of assets, maintain a reasonable or mandated liquidity level.  Diversification is another critical risk management principle: avoid overexposure or concentration in any credit, sector, tenor, country or equity.  Many discretionary managed portfolios invest solely in ETFs and index products.  At a blue chip American bank where I used to work, they pride themselves in having a robust risk management and investment protocol for the discretionary mandates. In order to maintain exposure to every asset class with the flexibility to adjust or terminate level of investment, they only invest in liquid underlying assets.  That’s where ETFs come in.  Even though you might not associate the humble concept with the most glamorous names behind hallowed business empires .  One of my favourite stories to share is a matriarch who opened an account and signed a discretionary mandate for balance portfolio, 20 years later she passed away and the estate went to her 4 children.  She had told them she had spread her risk with several banks with the same initial amount. When they showed up to sort out the estate, they were pleasantly surprised to find that after 20 years this one had grown 4 fold with an unsexy passive investment strategy that yielded approximately 7% p.a..  This family ended up consolidating their inheritance with this bank that advocated a conservative approach but over 20 years presented higher returns.  This traditional business model is never about making deals, never about the latest gimmick, never about the “hot pick” that fetches the most gains that year. It isn’t about providing clients with interesting conversations with their peers; it is about providing clients and their heirs with a basic income (annual or multiple distribution) and / or safety net (one-time distribution). 

Looking ahead, I expect the Gen Y (annd Z!) investors will take advantage of this passive investment strategies to free up their time and mental space and boldly devote their energy to the pursuits they deem worthy.  This generation is far more connected with their peers around the world; as a result the elite in Beijing will have more friends among the elite in California, in Moscow and in Saudi.  These international bonds were forged all over the world at boarding schools, super selective colleges, summer internships, specialised sports and music training programs.  Banks have been organising international programs for children of clients for decades-we do want to weave privilege-breeds-privilege international networking into the overall package we offer.  An elite groomed this way is likely to invest in much the same way as elites in his generation anywhere in the world.  The young elites of globalisation are more global and more elite than the previous generations, because they are groomed this way.  Canadian deputy prime minister Chrystia Freeland In her former life as journalist used to write and speak about the plutocrats of our era and one of her examples is the Silicone Valley technology entrepreneur identifying more with his bank owner friend from Africa than with his neighbours.  This analogy is perhaps all the more applicable among the younger set.

Young people anre also more involved with global issues like climate change, volunteerism, multiculturalism, feminism and social justice.  With social media and connectivity at their fingertips they are actually able to be part of any worldwide movement.  This generation has the tools that enable them to carve out their identities in international arena without the necessity of physical presence.  I imagine this approach to personal beliefs and life meaning will merge with volunteerism and reshape our idea of non profit work in the long run.  And in our egalitarian world where everyone enjoys only 24 hours a day, this set is likely to spend less time discussing their investment portfolios with their peers, let alone in active money management.

Gen Z, rightly or wrongly, has a reputation for being risk averse and anxious.  This is the generation that has a lower rate of substance abuse and teenage pregnancy, lower rate of minor traffic violations.  My guess is the most passive investment strategies will take flight in a big way when this group reaches majority and start to take responsibility of their inheritance.  The egalitarian nature of ETFs could well be perceived as a bonus to HNW Gen Z.  The previous generations have certainly basked in the social status associated with exclusivity (eg real estate and private equity club deals) and complexity (structures embedded with exotic derivatives).  The cautious and socially aware Gen Z would find daily liquidity much more reassuring than 10++ (years) lockup of most private equity investments. The uncomplicated ETFs would offer simplicity and transparency more appealing to our young investors than sophisticated derivatives-embedded of instruments.  In the US, private banking clients rarely venture into derivatives-embedded investments, but in Asia they have been in vogue and in great demand for at least 2 decades. The 2008 financial crisis saw the unfurling of the mother of all derivatives nightmares in Asia.  What started as a modest sell put contract in 2003 quickly became a McMansion of structured product with longer tenor, less favourable strike prices, reduced upside from additional barriers and eventually, leverage. These Frankenmansions, benignly christened “accumulators,” brought about vast wealth destruction in the financial crisis and earned the nickname “I kill you later.”  The story met with amusement and horror in equal measure when I told my colleagues in NY.  The lessons learnt would hopefully be imparted to the next generation just like other accumulated expertise such as social polish, business acumen, lobbying the government, establishing social status with non-profit engagement.  

Much as I enjoy the adrenaline rush of trading and participating in new issue deals, I am quite certaint the future will be much more about managed assets and discretionary portfolios. And I do anticipate 2 classes of instruments will experience a renaissance for completely new reasons: a) the plain vanilla money market, fixed income and equity instruments b) passive instruments giving investors exposure to all asset classes including alternatives.