How Rich People Invest
What does it take to be truly wealthy? Opinions on this question vary greatly, but by most accounts, people with at least US$ 1 million or Baht 40 million in financial wealth are members of an elite group of individuals around the world call “mass affluent”. They account for 0.2% of the global adult population and nearly one fourth of the world's wealth. High Net Worth Individuals (HNWIs ) as they are often referred to can be broken down into 3 major categories. Right at the bottom is the so-called “mass affluent” and these are the people with US$ 1-5 million in financial wealth. According to the latest World Wealth Report by Merrill Lynch and Capgemini, there are 7.44 million people in this category in 2004. Move one notch up, then, there are the Mid-Tier Millionaires . These are people with US$ 5-30 million in financial wealth, to which there are 0.74 million of them around the globe. Then, we have the pinnacle right at the top of the food chain; these are called “ Ultra-HNWIs ”. To be qualified, one must have at least US$ 30 million or Baht 1,200 million in financial wealth and as of last count; there are only 77,500 of these people around the world. As expected North Americans and Europeans make up the bulk of the HNWIs with Asian-Pacific, Latin Americans and Middle Easterns lower down in the pecking order of global wealth .
Now that we know what it takes to join the HNWIs Club, in this issue of M&W we will try to shed some light on how rich people invest differently from ordinary folks like you and me.
While 2003 was recognized as a year of recovery from an economic slowdown, 2004 can be described as a year of stabilization. With interest rates at historic lows globally, world GDP grew at its fastest pace in over 20 years. Stock market capitalization also increased steadily across the world, buoyed by economic stability and low cost of money. Together the driver of wealth- GDP growth and increase in market capitalization accelerated gains in personal wealth. By comparison to 2002 and 2003, which saw the wealth of HNWIs grow at rates of 2.7% and 7.7% respectively, 2004 was a better year, with worldwide HNWI financial wealth growing at 8.2%. Despite these gains, HNWIs adopted a more cautious approach towards investment and asset allocation in 2004
In 2002, which was not a good year for equities- stock markets under-performed other asset classes and HNWIs sought refuge in low risk assets such as fixed income and cash/deposits. 2003's return to more favourable economic conditions, including a marked upswing in stock market performance and a record low in interest rates, lured HNWIs back into equities and heightened their interest in alternative investments. The Dow Jones World Stock Index gained 33.4% in 2003, while the SET went up by 116%. However, in 2004, rising oil prices and interest rates produced lower stock market returns of 14.4% on a global scale with the SET sinking into negative territory of 13%. With returns drifting lower and market volatility increasing in 2004, HNWIs leveled off their commitments to equities. As the year progressed, HNWIs allocation strategies grew more conservative and diversified. In fact, their maturing financial sophistication can be seen in their growing interest in and reliance on a wide range of alternative investments such as private equity and hedge funds. Private Equity: This is an area where only Ultra-HNWIs and institutional investors can afford to play because the minimum investment threshold is quite large and it is a fairly high-risk asset class where quite often the bulk of the investments are in non-listed or start-up stocks. Indeed, the US Private Equity Index, with returns of 23.5%, outperformed other major market indices in 2004.
Hedge Funds: This asset class accounts for a growing share of HNWIs' alternative investments, having become an integral part of most private banks' standard offerings. In fact, there are now nearly as many hedge funds in existence as there are mutual funds. Although, the returns in US Hedge Fund Index have declined from 17.2% in 2003 to 7.5% in 2004 but more often today, hedge funds are seen as a route to portfolio diversification rather than as a heavy-return generator. The hedge fund industry has responded to broader interest in its products, by targeting smaller i.e. less affluent investors with “funds of hedge funds” . Minimum investment levels in these new funds can be as low as US$ 25,000, significantly less than the US$ 250,000+ amounts typically required by hedge funds. This is just one more example of how high-end investment opportunities that were once the exclusive domain of institutions and Ultra-HNWIs are being modified and made available to “mass affluent” individuals. Currently, “funds of hedge funds” account for more than 25% of the hedge fund market. Real Estate: HNWIs' real estate allocations declined over the last year from 17% in 2003 to 13% by the end of 2004. This is in sharp contrast with broader market trends of price inflation and stepped-up speculation brought on by record low mortgage-interest rates. The price of the median single-family home in the US rose by 7.4% in 2004, following a 7.5% increase in 2003. And even though interest rates increased in 2004, pushing borrowing costs higher and pricing countless potential homebuyers out of the market, property prices have not yet dropped. Furthermore, prices in many regions have grown faster than household income or rent, providing more evidence that real estate has become overvalued. Further indication of a pending slow down: Real Estate Investment Trusts' (REITs) returns were lower in 2004 than in 2003. Indeed, overall apartment REITs were hurt in previous years as the affordable housing market turned renters into homeowners. As HNWIs grow steadily more risk averse in 2004 than they were in 2003, the fact that they now perceive real estate as a riskier investment justifies HNWIs' adopting a more cautious approach towards this asset class. This behaviour, which appears to be in anticipation of the sector overheating, is consistent with the belief that HNWIs are, in general, more informed than the average investor and, also, possess the means to reallocate resources ahead of main market trends.
Regional Differences in Asset Allocation Strategies
In North America , equities remain the asset class of choice among HNWIs, winning 41% of their investment dollars. While this trend now seems to be fading slowly, North American portfolios remain the least balanced among asset classes, with HNWIs here showing far less interest/allocation in alternative investments than their counterparts in Europe, Asia-Pacific and the Middle East . In 2004, the portfolios of HNWIs in the Asia-Pacific region held the most equally distributed asset classes of wealthy individuals in any region. As expected, real estate allocations were high in this region, accounting for 19% of HNWIs' portfolios. Only European HNWIs allocated more-21%- of their portfolios to this asset class, the majority of which are in direct real estate. Portfolios of European HNWIs are also well diversified, with 25% in equities and 24% in fixed income assets. As for Latin American HNWIs, their asset allocations are largely shaped by traditional investment behaviours with conservative strategies to preserve wealth in the region's high-risk, difficult-return environment. Consequently, their equity allocation was the lowest of any region in the world, at 18% with 25% in alternative investments and the rest in fixed income.
HNWIs Use Foreign Investments to Diversify
Two diversification trends gathered momentum in 2004: Emerging economies continued to attract HNWIs' investments, with the MSCI Emerging Markets Free Index returning 24.3% in 2004, far higher than the 6% to 13% returns possible in either European or American markets. As a result, Asia-Pacific benefited from outflows of investments from North America, Europe and Latin America . North America remained the preferred region for investment, drawing a substantial range of allocations from offshore investors, from a low of 28% among Asia-Pacific HNWIs to a high of 46% from wealthy Latin Americans. However, growing fear of a crash in the US Dollar led to broader foreign investment diversification among HNWIs in all regions. Consequently, North America 's overall share of non-North American HNWIs' assets dropped from 48% to 38% in 2004. Even in the United States , where investors traditionally favour domestic investments, overseas holdings grew to 30% of American HNWIs' financial assets.
Tax HeavensBermuda, the Cayman Islands and British Virgin Islands continued to be the locations of choice for HNWIs' tax protected investments. However, in the light of HNWIs' more sophisticated investment behaviours, specialized safe heavens have become increasingly popular, with Panama , Liechtenstein , Hong Kong and the Isle of Man most often cited as preferred destinations for specific asset classes.
Cost of Living Extremely Well Index (CLEWI)
Once again we come back to the question of what does it take to live well? “Really” well for that matter! The answer to that question is of course relative. Different people have different definitions to the notion of living well. Sure enough, living in a lap of luxury is not cheap and here's a glimpse of how the other half live their lives. And when I say the “other half” I mean the rich half of course. For millions of ordinary people, making ends meet on monthly salaries is hard enough as it is but for the Ultra-HNWIs, life is even harder at the top and here's the reason why. In 2004, the ultra-wealthy population segment grew more quickly than those more broadly termed high-net-worth-individuals (HNWIs). During the year, 6.300 people, a 8.9% gain, joined the uppermost ranks of the world's riches individuals, compared to a more moderate 7.3% population increase for HNWIs overall, according to the latest World Wealth Report by Merrill Lynch and Capgemini. While this trend meant that more people could afford the finest things in life the world has to offer, price inflation for top-of-the-line luxury goods and services rose at a faster pace than massed produced consumer products. According to Forbes Magazine's Cost of Living Extremely Well Index (CLEWI), price change to a “basket” of luxury goods and services rose 4.2% in 2004. By contrast, during the same 12-month period, the US Consumer Price Index (CPI) rose by only 3%- evidence that luxury goods and services are subject to different inflationary pressures than those consumed by the public at large. By using CLEWI as a base, the World Wealth Report has created two modified indices that separate Ultra-HNWIs luxury consumption from that of the HNWIs. The Ultra-HNWIs index focuses on price changes of products and services typically reserved for the wealthiest individuals such as private jets, Rolls Royces, luxury yachts etc., whereas the HNWI basket of goods contains relatively lower-priced items in the same categories such as first-class airfare, BMWs, motor yachts etc.
According to the Report, the Ultra-HNWI index rose by 11.3%, while goods and services more broadly favoured by HNWIs increased by ONLY 6.4% between 2003 and 2004. Clearly, in this time period, the price inflation for ultra-luxury products was considerably stronger than that of more moderately priced luxury items. This rising trend-line translates into a two-fold challenge for Ultra-HNWIs: To maintain their lifestyles and purchasing power, the world wealthiest must not only closely manage the people who manage their wealth but they must also contend with an inflation rate that is nearly four times higher than the “regular” inflation that you and I are accustomed to. Poor them.