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Private banks once conjured up images of Chesterfield sofas, cigars and the occasional stock tip exchanged in a wood-panelled office.
The bursting of the stock market bubble changed that. Seven years on, private banks have emerged with a solid focus on investment performance and a new mantra – asset allocation.
Wealth managers – as private banks are increasingly called – have shifted away from the brokerage model of selling a range of products in return for commissions. Instead they are trying to be allocators of assets, advising clients on the range of their portfolio including their exposure to share options, property, hedge funds, private equity and other assets.
John Skjervem, chief investment officer for Northern Trust’s personal financial services business, says the bear market was the catalyst for a big change in attitudes towards performance.
“The shift was from predominantly closed architecture and proprietary solutions to blended or open architecture solutions,” he says.
“But more important was a painfully learnt, newfound appreciation for diversification.”
Private banks have long prided themselves on discretion and tailor-made financial management for the very wealthy. For the clients, quality of service is what has distinguished one provider from another.
Where does investment performance fit in?
When IBM Business Consulting Services asked private clients why they picked their provider, investment performance ranked below quality of service; confidentiality and security; quality of investment advice; image and reputation; and referrals from existing clients.
But when a private bank tripped up on performance, clients had a different perspective. IBM’s European Wealth and Private Banking Industry Survey 2005 found that poor investment performance and advice were among the top three reasons clients changed their private banking provider.
Michael Cembalest, chief investment officer for JPMorgan Private Bank, says one reason investment performance ranks higher when someone is dissatisfied is that when an investment adviser loses money, the client “looks under the hood”.
“People will fire you for investment performance when they think you have taken on unnecessary risk,” he says.
Mr Cembalest believes investment performance comes and goes in terms of where it ranks on the list, depending on the market cycles.
“In 2001 and 2002 it was extremely important. People wanted to see proof that you were taking concrete steps to preserve their capital at the time that the markets were plunging,” he says.
But, he adds, performance matters more or less depending on the private bank’s other services, which could include trust and estate planning, tax advice and philanthropy. For example, if a client is in a jurisdiction with no taxes, the chances are that investment performance will matter more, because less advice is needed around the other topics.
What constitutes performance?
“Some combination of beta [returns that follow the general market trend], alpha [returns not linked to the market – what a manager produces over and above the general trend] and leverage are the components of everybody’s portfolio,” says Mr Cembalest.
“As a non-believer in bet-the-ranch, I try to make sure that our strategies and portfolios have a little bit of everything.”
He believes it is “unnecessary bravado” for a private bank to have an investment approach that rests primarily on manager selection.
“Last year our manager selection was just okay. Almost all the managers on average were top quartile but that didn’t add a lot of value over the markets.
“Last year our value added was because we made some smart decisions in terms of a modestly weaker dollar and better performance in international equity markets than in the US.”
Performance is about more than the numbers.
“[Investment] performance counts but so does the quarterback who advocates broad diversification and prudent asset allocation,” says Northern Trust’s Mr Skjervem.
Christopher Wolfe, chief investment officer for Merrill Lynch’s private banking and investment group, says the performance discussion has assumed “a greater depth and breadth” in recent years and should take place in the context of increasing a client’s wealth after tax and inflation.
“That, by a lot of definitions, is success. But there are very few people who think in the real return space,” he says.
“[Performance] is not only about asset classes but the totality of how these things work together. It is not just about a number but about how you got there.”
Mr Wolfe believes after-tax performance will take on greater importance in the coming years.
“First, we are on the cusp of a massive wealth transfer over the next 15 to 20 years and how taxation is handled will be a factor,” he says.
“Second, tax regimes have started to bottom out. I’m not sure tax rates are headed much lower. Globally we’ve seen tax rates in some jurisdictions start to rise.
“Third, historically there has been a relationship between after-tax performance and market volatility. As market volatility rises, we will see a greater distinction between before and after-tax performance from managers.”
Private bankers say some clients who have experienced a “liquidity event” – say, from the sale of their business – have unrealistic expectations for investment performance.
“We have seen a lot of entrepreneurial wealth being created through financial markets transactions – initial public offerings, buy-outs and private equity deals,” says Mr Wolfe.
“This explosive wealth does set expectations that are often too high, and for those types [of clients] there is a lot of time spent managing those expectations.”
Mr Cembalest agrees. “A lot of clients generated compound returns of 30 to 50 per cent in the operating business they were in, so sometimes they have different expectations for what they are expecting out of an investments portfolio,” he says.
“We try to explain to them that we are not in a horse race between an operating company that has financial leverage and operating leverage and high failure rates. That is not what investment portfolios are designed to achieve.”
One of the more difficult aspects of choosing a private bank has always been evaluating investment performance. Because of the confidential nature of private banking, relative performance is tough to compare.
That is changing. Last year, London-based Private Banking Index, in conjunction with FTSE Group, launched a series of private banking benchmarks. Every month, 40 private banks based in Europe supply, in confidence, their asset allocation across seven asset classes, four currencies and three risk levels – for a total of 12 portfolios.
The result is the FTSE Private Banking Index Series, which provides a benchmarking tool for private banks’ clients to measure the absolute and relative performance of their investments and of their wealth managers.
“Private banking was the only remaining bastion of financial services that didn’t have its own index,” says Ariel Salama, PriBIL’s chairman.
“Performance is becoming part of the strategy of private banks in terms of business expansion, and so in addition to good services and the wooden panels in their offices, they can now talk about performance.”
For now the index series is available only for European institutions but a US version may be in the offing.
“The directional move for greater transparency on performance is a good thing,” Mr Wolfe says.
“The risk is that it becomes the only measure – a report card, if you will – that has the risk of facilitating performance-chasing by clients, which is a very expensive hobby.”
Mr Cembalest also welcomes transparency but cautions that risk cycles are not measured annually.
“If you looked back to 1987, 1994, 1997, 1998, 2001, 2002 and more recently 2007, you really needed to get a three to five-year look at someone to get a look at whether they were swimming with their trunks off.
“The private bank that posts the biggest return in a bull year will be the one everybody says, ‘Well, we should be working for them because in 200X they had the biggest return.’
“Whereas you have absolutely no way of knowing what risks they took to get there, unless you are going to look at something over a longer cycle.”
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