Private Banking: the quality of the investment portfolio (1)

on March 19, 2015 Data crunching, Uncategorized with 0 comments

 

Part 1. From data to insights

This blog is a start of a triptych. This time, Decisive Facts will focus on real life examples of a large Dutch Private Bank. A private bank only delivers financial services to wealthy individuals and institutions who have more than EUR. 500.000 available. The limits differentiate per bank. The capital of these wealthy people is mostly invested in the economy. In the rest of this post we will refer to Private Bank X.

Decisive Facts helps with this process of finding new ways of thinking and working with an innovative technical solution.

The content of this triptych is:

    1. From data to insights
    2. Mobilizing the organization
    3. Cash the result

 

In this first part we will start with 1: From data to insights.

Investment in the past 20 years

In the second half of the 90’ies, investment in shares became broadly accepted. Investing was seen as a quick and easy way to become rich. Not only the stock exchanges had a lot of investors, but also options became popular. With their own money, borrowed money or other constructions people tried to multiply their money. When people got mortgages, they loaned extra money to invest. They thought that the whole mortgage could be relieved with that small investment.

Private Banking

 

The graph above shows the trend of the AEX-index, the most important stock barometer in the Netherlands. In this index are the 25 most traded shares of the Netherlands combined. When we focus on the 1995 – 2000 period it is not hard to imagine the attractive force of investment: It tripled in 5 years!

 

A whole industry was built around the stock exchange: investment advisors, analysts, marketers and developers of new investment instruments. Everybody was happy as long as the markets kept growing; clients saw their capital rise and the industry flourished.

World Online came to the stock exchange at the top of the market. Their shares started dropping almost directly after their IPO. Mostly ICT related funds were hit hard by the dot.com crisis. An Example is KPN. When somebody invested € 10.000 in the national telecom giant in the year 2000, there was only € 1.000 left 2001. Even after 12 years there was at least € 1.000 less left than the initial investment. While it should after 12 years, with a computational efficiency of 8%, at least be € 25.000!

Private Banking

A lot of clients turned their back on investing after the popping of the internet bubble in 2000/2001. The reaction of the investment industry was to focus on other products: bonds. The risk of these bonds was lower than at the stock exchange, and thus the expected efficiency was also lower. This lower efficiency caused that the industry could no longer afford to pay their clients big commissions to which everyone was so used to. The solution was a creation of complex constructions with funds, which had a higher efficiency and from which both clients and the industry made more money. Forever lasting funds (perpetuals), special investment vehikels (CDO/CLO) and an even larger collection of difficult structures which features cryptically names of 3 letters.

In 2007 a second financial crisis appeared, cause by the pop of the mortgage bubble in the VS. This had large implication for the worldwide financial market. A lot of these mortgages where financed by a various collection of fund structures which were less resistant to a large decrease of the value of the mortgages than the risk-departments of the established banks thought.

Two crises within 10 years: time for reflection

The year is 2009. The developments on the financial markets and at the industries cause reflection at Private Bank X. What happened? What is our vision? How can we best response on these market conditions? What is the added value that we offer to our clients? The management decided to gather experts of different disciplines and diagnose the situation.
The experts came, after a detailed research, to the following conclusions:

  1. The research into the trust of the client needs a reality check. The role of analysts and advisors is overrated; they cannot predict the future. Client have to be warned for this fact, but this is not an easy task. The clients are usually the one who ask for advice and they think it is the banks which has to lead them into the good direction.
  2. The risk-management inside the bank has to be strongly improved. The current risk management system of the bank is not effective. I appears to be an airbag which does not work with a frontal collision.
  3. There has to be a critical evaluation of the different products. Products that have a high efficiency and a small risk does not exist. We have to be prepared to lose clients if they want to buy bad products and threaten to leave if we don’t sell them. Even if these clients have high credit ratings.
  4. The information supply to costumers has to be more transparent and complete. We have to gather information about (not visible) costs of investment titles and clients and take this into account in our advice.
  5. There has to be more attention for costumer survey. That will cause proper services for every client, also already existing clients.

 

A nice list. A list that is way more challenging than first meets the eye. The problem is that it will go directly into all established principles within and outside the bank. Besides this, the business model of the investment department is called into question, without bringing forward a clear new model. The management of the bank decides that there has to be more movement, in which they will connect with the client. A team is created to realize this. In this further post they are different subjects explained which the investment teams discussed with their clients. The following:

  1. Wide spread best weapon against price drops
  2. Buy not (only) Dutch equities
  3. Need for funds, focus on cost
  4. From reflection to implementation

 

1. Wide spread best weapon against price drops

A share can suddenly drop down. Scandals in companies like World Online and Ahold in the Netherlands, and Enron, Worldcom, Parmalat and abroad, are showing this. Also it can unfold a disaster like the Deepwater Horizon scandal of BP. Or fraud by an individual as a rogue trader Nick Leeson (Barings Bank) and Jérôme Kerviel (Societe Generale) can have enormous consequences on the stock price of the underlying companies that can not be foreseen. Or fraud by an individual as rogue trader Nick Leeson (Barings Bank) and Jérôme Kerviel (Société Générale) can have enormous consequences on the stock price of the underlying companies that can not be foreseen.

If analysis and advice about a company offers no protection against large price declines, what can you then offer your clients? Give advise on diversification.
The expert team of Private Bank X shows that with a broad spread the risk, that a poorly performing share helps the efficiency of the entire investment portfolio, is restrained.
A spread over at least about 50 stocks in different regions and sectors is preferred.

2. Buy not (only) Dutch equities

Many Dutch investors have a strong preference for Dutch equities, and invest little or not ‘over the border’. This is called a “home bias”: investors prefer companies from their own country, because these companies are more known to them and therefore more predictable according to the investors. The spread to several countries, there is not for them.The spread to several countries, there is not for them. But they also often invest only in the AEX (large companies) or AMX (medium enterprises) funds. The composition of the AEX and AMX indices is very unbalanced in terms of diversification to sectors and industries. Portfolio diversification is clearly preferable.

The investment team of the bank is therefore set to work to make evidence that this is a choice that is not optimal for the preservation and growth of capital. If we look, the experts seem to have it right on their side. The chart below compares the AEX index with the MSCI World Index (1611 shares of 23 developed countries). Dutch funds are not active in the innovative technological angle, so the index remains well behind.

Private Banking

3. Need for funds, focus on cost

The advice to diversify an investment portfolio of at least 50 shares has another consequence. The cost of holding one specific share is forcing investors to at least € 10,000 to invest in any stock. A customer who invests all of its assets in individual stocks should therefore at least have a capacity of € 500 000 (50 shares at least € 10,000). If he invests half of its assets in equities and half in bonds, so a balance of € 1,000,000 necessary.

Most customers of Private Bank X do not have this ability. One solution is to invest in mutual funds. With a mutual fund, it is possible to invest in a large number of shares. One drawback for many investors is that they can pass on the choice of the shares.

With the focus on funding there is a new issue: A question about the costs and returns of actively managed mutual funds versus passively managed and cheaper alternative.

Mutual funds are called expensive. On average they cost around 1.8% of the investment per year in direct costs. This cost is the customer’s lost, regardless of the performance of the fund. At the head of a mutual fund is a fund manager. A fund manager decides which stocks are included in an investment fund, and the relative weighting.

A cheaper solution is to passively invest in an index tracker. The choice and the relative importance of shares is automatically determined here, by following a broader stock index. Because this can automated, there is no expensive fund manager needed. An index tracker will cost on average only 0.5% per year.

If we only look at costs, the advice seems easy: investing exclusively in passive index trackers and let the expensive actively managed mutual funds aside. But that is too short-sighted. Because if the fund managers on average better return than a cheap passive alternative, they may still be the best choice.

Analysts make a simple analysis. Suppose someone invests € 100,000 in a mutual fund at 1.8% per year and cost the same amount in an index tracker at 0.5% fee per year. And what if they both have the same result in the long term: 8% annualized return. What does this mean for the precise return – after deduction of annual costs – after 25 years? Through the magic of the interest-on-interest securities capacity increasing faster than might be expected. Simple math dictates that the return of the actively managed fund remains strong, because we assume that the return is the same, but the cost is more than three times as high. After 25 years there is a difference of € 160,000 to the detriment of the actively managed fund! Roughly the cost of maintaining a half child from cradle to job (including study)!

Investing is not just a matter of risk and return. Costs also play a significant role. Of course a sensitive issue for suppliers of funds. The consequence for Private Bank X is that they also have to record index tracker in their range.

Private Banking

4. From reflection to implementation

With these and a number of other detailed topics, the team of investment professionals goes on the move. They realize only too well that they received a challenge on their plate where they will have a tough one. The movement that they need to put in motion, namely has many implications for different stakeholders. For the internal organization, the relationship with suppliers, other parts of the bank and the most important: the customers. Next week we will look at the process of change that goes with this.

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