TRICKY DAYS AHEAD FOR HIGH-NET-WORTH INVESTORS
High-net-worth (HNW) investors have faced some challenging times since the financial crisis passed nearly 10 years ago. The asset classes and strategies they invest in have performed well, but members of the “stay rich vs. get rich” set have never forgotten that existential threat to their wealth and lifestyle.
As a result, many of them have missed out on some or most of a bull market that rivals almost any in history in both amplitude and length.
As 2017 closes with most markets at record highs and interest rates still near record lows, here are a few thoughts about how they — and you — might navigate the equity and bond markets in 2018.
EQUITIES
To the extent the stock market reflects the economy, it seems, at least in the U.S., the economy is in excellent shape. Unemployment is low, GDP is growing and the new U.S. tax reforms should provide some rocket fuel, at least in the short term.
On the flip side, valuations are extremely high and the current cycle is in its late innings (or even extra innings). Markets have increased with a growth-atany-price mentality, and it’s hard buying in at current levels.
For Canadian HNW investors, two primary shifts started as early as a year ago.
First, there has been a flight to quality in the form of old-fashioned Buffett-style value stocks, since most see a correction in equity markets as an if, not a when, situation.
Value as a strategy (seeking companies trading at relatively low prices in spite of high returns on equity, low debt to equity ratios, proven longevity and high-quality management teams) has been shunned in favour of investing in the big-five tech (a.k.a. FAANG) stocks, whose gravity-defying price growth would never survive a value test.
This is a common theme in bull markets: value investors do so-so while growth investors prosper.
The pendulum, however, must inevitably swing back, and when it does, value investors always get hurt the least and rebound the fastest, since what they own has more to do with reality than just market sentiment.
The second shift involves moving away from a home-country bias. Historically, Canadians could buy a basket of blue-chip homegrown stocks made up of banks, telecoms and utilities and expect reasonable growth and high dividends over time.
Now, many see a tectonic shift where Canadian companies may fall well behind those in the U.S. and other countries because of high taxes, a move away from a manufacturing-and-resources global economy, and an uncertain future for the North American Free Trade Agreement.
Ask yourself, “If I lived in the U.S. or Europe, what percentage of my equity investment would be in Canada?”
The answer is somewhere between three and five per cent, and that’s exactly how many HNW investors are positioning themselves.
By seeing themselves as citizens of the world, Canadian HNW investors can unshackle themselves from having to fish in a relatively small pond and open up to the same global markets that U.S. and foreign investors consider.
FIXED INCOME
Anyone screaming from the rooftops for the past three years that owning unhedged bonds and exposing yourself to potential interest rate hikes is lunacy has been proven wrong, because central banks have been intent on keeping the easy money flowing and the markets buoyant.
But there has been a clear message from both central banks and the markets in recent months: rates will eventually rise.
Owning bonds — especially investment-grade bonds — has always represented the conservative part of HNW portfolios, throwing off interest while acting as ballast against potentially volatile stock holdings.
But a triple whammy for investment-grade bonds looms: interest rates are too low to provide meaningful income (especially after the government takes more than half in taxes); inflation, while low, will surely chip away more in the spending value of the principle each year than what is left in interest after tax; and interest rates will eventually ( but certainly) increase, eating away at the value of bonds with fixed coupons at current levels.
In other words, you will likely lose money on an after-tax, inflation-adjusted basis in real time, all the while holding an asset that will surely eventually decrease in price. As a result, HNW investors have begun turning to other assets, including high-yield bonds, preferred equities and, most notably, private-debt and credit-hedge strategies.
With private debt, HNW investors give up some liquidity and price discovery in exchange for the higher returns the private markets can offer. Because of their long investment horizons, low liquidity requirements and ability to perform real due diligence, these investors can be less concerned with low yields, inflation and/or rising rates.
Similarly, credit-hedge strategies, usually run by former “prop traders” from banks now legislatively proscribed from trading on their own balance sheets, involve trading investment-grade bonds while applying modest amounts of leverage to increase yields, and shorting government bonds to hedge interest rate exposure.
This strategy insulates the risk investors take in leveraging credit, all but nullifying the rate risk inherent in unhedged bond investing.
BITCOIN AND MARIJUANA
Every meeting we’ve had in the last few months has included a discussion about cryptocurrencies and cannabis. Yes, even rich people like to hit it big every once in a while.
But HNW investors can take meaningful positions on a flyer without affecting their lifestyles in the event of a total loss. Most other people can’t.
Some ordinary investors are treating cryptocurrencies like a legitimate asset class. They are not. Anything that moves 20 to 30 per cent in value per day is not a legitimate investment; it’s pure speculation.
As for cannabis stocks, the train has not left the station. Similar to the years following the end of prohibition, we may very well see the rise of legitimate marijuana growers and distributors, but blindly betting big on the space today is likely a recipe for disaster.
THE BOTTOM LINE
The biggest difference between HNW investors and ordinary investors is that the former have the greatest ability to withstand losses and, that notwithstanding, are generally much more conservative in their allocations.
As the markets enter 2018 on a virtual tear, HNW investors are spending a lot more time preparing for the inevitable correction that must one day arrive than on assuming the current wave will never dissipate.