With this post we continue our investigation of the management of illiquid wealth in closely held and family businesses (The One Percent Solution) with a discussion of liquid wealth. By comparing and contrasting these two general forms of wealth, we can begin to understand the principles necessary to manage illiquid wealth.
Liquid Wealth Defined
Liquid wealth is, well, liquid. Liquid wealth is comprised of securities of many kinds that are traded in active, or relatively active, markets. The wealth management business, which focuses primarily on the management of liquid wealth, is well developed. The management of illiquid wealth in closely held and family businesses is a new and developing frontier.
The market capitalization of the S&P 500 Index is some $15 trillion (June 2013). There are thousands of other publicly traded companies with equity and debt securities. The bond markets include taxable and nontaxable (municipalities and states) sectors, and securitized assets of many classes now trade publicly. There is a massive amount of liquid wealth in America.
How Liquid Wealth Is Managed
Liquid wealth is typically managed by asset management firms. The top 15 such firms in the world as of June 30, 2012 (www.relbank.com) collectively manage some $25 trillion of assets. As “they” say, “That’s a lot of dough!” Some of these assets are, of course in alternative investment classes, but the majority of these funds are liquid in nature.
Most readers are at least passingly familiar with some or many of the names in the list above. There are, of course, several thousand other asset management firms in the United States that have assets under management (“AUM”) ranging from less than $50 million upwards to many billions of dollars.
Whether your liquid funds are managed by one of the titans above, or by a small, boutique, specialty firm, the customers of asset managers range from individuals to corporations to financial institutions to profit sharing and other retirement plans to insurance companies to the endowments of universities and hospitals and so on. Many owners of closely held and family businesses have liquid assets managed directly or through retirement plans with asset management firms, as well as other funds that may be similarly managed.
Compensation for Management of Liquid Wealth
It is almost axiomatic in the field of wealth management that money managers are compensated based on percentages of the assets they have “under management,” and so we have the term, assets under management, and the acronym of AUM. The percentages might range from 20-30 basis points for bonds and other fixed income securities to 50 to 100 basis points for basic equity portfolios, to 150 basis points (1.5%) or more for private equity portfolios, venture capital funds, or hedge funds.
Money managers charge their fees for your AUM, i.e., your assets under their management, generally quarterly, sometimes in advance and sometimes in arrears. I’m not aware of any managers who do not charge fees. Asset management fees are usually in the form of an annualized basis point (percentage) charge against AUM. This is not at all a criticism of asset managers. You charge for your products and services and I charge for mine.
The point is, you and I and virtually everyone else who has liquid wealth managed by asset managers (or wealth managers, or by whatever name), pay regular management fees based on our AUM, or our wealth under management. To put a number to it, assume that an asset manager charges 1% of AUM for the management of equity portfolios. Assume that Mr. Jones has a portfolio of $5 million entrusted to this manager. The manager is charging Mr. Jones at a run rate of $50 thousand per year (i.e., 1% times $5 million) for management services.
Let’s hold the thought of fees for assets under management and we’ll reintroduce it as we talk about private wealth in closely held and family businesses.
The first mantra of liquid wealth management is diversification. According to modern portfolio theory, there are two kinds of risks that investors face with respect to securities.
- The risk associated with individual securities. Bad things can happen to all businesses, even good companies, and good things can happen to bad or good companies. When you own an individual security, you can hope it will go up in price, and it might. But disaster might strike.
- The risks associated with the market in general. If the market tanks, even a strongly performing company’s shares may decline. Just as a rising tide lifts all boats, a falling tide tends to take them down.
The first solution to this mixture of risks is diversification. Modern portfolio theorists suggest that if an investor owns perhaps 15-20 equity securities, the bad things that happen to some companies will, on average, be offset by good things that happen to others. The result is that a diversified portfolio of stocks should hope to achieve the “return of the market.” That is why diversification is a mantra in the management of liquid wealth. But the return of the market may be horrific for certain periods.
In business valuation, we are always concerned about concentrations, e.g., of customers. An extreme customer concentration creates risks. I’ve been in business for a long time now and I’ve learned at least one thing about customer relationships: every customer relationship has a beginning, a duration, and an end. If the customer relationship that ends this period is your large customer, then bad things happen, possibly even going out of business.
The principal of diversification of investments is similar. You just don’t want to be around when one of the three or four companies in your portfolio falls on bad times and its stock plunges, just like you don’t want to be around when you lose that single, large customer. The principal of diversification is all about managing and controlling risks associated with investment concentrations of individual securities.
Diversification is good, however, it will not protect against broad declines in the equity markets. Too recently, we all experienced the 50% drop in both the Dow Jones Industrial Index and the S&P 500 Index between October 2007 and March 2009. Basically, if you owned stocks during that period of time, your portfolio values declined. Mine certainly did.
Therefore, the second mantra of asset management is asset allocation. Asset allocation is a form of diversification of the mix of the various asset classes held in portfolios. Take a simple example, which may shed some light on the matter. Assume a portfolio is invested in two diversified subportfolios, with one holding a mix of equity securities and the other a mix of exposure to the fixed income markets (i.e., bonds for short). Let’s say that the mix is 60% equities and 40% bonds.
The theory is that the movement of stocks and bonds might be “uncorrelated.” This might mean that when equities are falling, general conditions in the bond market might be such that bonds hold their value or even rise in value. Or, the example could work the other way, as well. By investing in more than one asset class, the overall risk of the total portfolio should be reduced because different assets perform differently as economic and market conditions vary.
If any current, well-trained CFA charterholders reads this, don’t cringe. I’m oversimplifying intentionally.
Asset allocation is really an investment strategy that seeks to balance investment risks and rewards of an investment portfolio by making “asset allocation” decisions between asset classes based on the risk tolerances, investment time horizons and investment objectives of particular investors.
Assets might be allocated, for example to large capitalization stocks, international equities, fixed income securities, small capitalization stocks, corporate bonds, mortgage-related securities, and so on. In addition, assets are also sometimes allocated into “alternative investment” categories of less liquid assets, including private equity, hedge funds and a variety of other relatively illiquid categories.
Investors make portfolio (i.e., asset allocation) choices. Wealth managers assist them in making those choices and then, in implementing specific investment strategies designed to achieve their objectives. We met Mr. Jones, who has $5 million of liquid assets a moment ago. His financial advisor has implemented an asset allocation strategy for Mr. Jones based on the principles of diversification and asset allocation just as we have discussed.
Mr. Jones’ portfolio has large capitalization stocks, smaller cap stocks, international equities, bonds and some cash. Roughly, this manager has concluded, after working with Mr. Jones, that a broad asset allocation of about 65% equities and 35% bonds and cash is appropriate, and the portfolio is invested as in the pie chart below.
The portfolio is “diversified” through its asset allocation scheme, and the individual components of the portfolio should be diversified as well.
Mr. Jones’ portfolio manager is sleeping well at night because he has invested the portfolio in a manner that is consistent with Mr. Jones’ stated objectives, and that provides both income and growth prospects and the “protection” of the asset allocation scheme.
But read on as our story progresses. We’ll learn more about Mr. Jones shortly and find out if he should be sleeping well at night.
What about this brief discussion of liquid wealth resonates with you? What else do you believe should be discussed? Feel free to comment or to call (901-685-2120) or email me with suggestions.