Wealth Management

It is the first job of private wealth managers to help create, from among various investment strategies, income or growth sufficient for the everyday needs of their clients. In addition, they must provide enough excess growth to account for inflation in order that their clients’ purchasing power does not erode over time. In addition, hopefully the wealth manager will continue to grow the clients’ assets so that they become richer.

Since the wealthy often need to live solely off of their investments, private wealth managers must use a variety of investment techniques to help clients create sufficient annual income.

Sounds easy enough, right? Not really. When you consider that someone who invests $1 million in a conservative corporate bond returning 5 percent creates a modest $50,000 a year in income, it becomes obvious that having $1 million dollars or so just isn’t as big of a deal as it used to be. Sure, $50,000 is an okay amount of money for doing nothing, but it falls under the U.S. average wages of $65,740 in May 2023, according to the U.S. Department of Labor, so living on champagne and caviar is out of the question. Bear markets in the early and late 2000s show that the job of private wealth managers in creating income for their clients isn’t always easy.

Paying Taxes

Another problem wealthy clients often encounter is taxes. None of us likes paying taxes. For most of us, however, we would willingly pay additional taxes if it meant that we were making additional income. For the wealthy it isn’t quite so simple. When managing large pools of assets, small differences in tax rates can translate into big changes in after-tax returns. Various types of investments used are taxed differently by the IRS. For example, income derived from the interest rates of bonds is taxed differently than long-term capital gains derived from selling stock. It is the private wealth manager’s job to balance assorted types of investments to create the most tax efficient combination for the client.

Wealthy people are also subject to inheritance taxes. Accordingly, private wealth managers must help their clients select from a number of products or legal entities, such as trusts or insurance, to preserve their estates after their death. Private wealth managers are prohibited by law from offering legal advice (a right reserved for lawyers), but they must be well versed on the various laws regarding trusts and estates. Additionally, private wealth managers often have insight and experience in managing charitable investment entities, such as endowments and foundations.

In today’s society, people with money are sometimes targeted with lawsuits just because they happen to have money. So, an increasingly popular area of practice for private wealth managers is called “asset protection,” which helps the wealthy guard against losing money in civil lawsuits. There are several techniques used to protect assets, including U.S. trusts laws and foreign, off-shore banks. Advocates of asset protection methods contend that making their clients impervious to lawsuits doesn’t just protect assets, but also prevents lawsuits from even happening.

Though the above are some of the main areas in which a private wealth manager will work, they are certainly not the only ones. In general, clients will often rely on advice from their private wealth managers for a variety of decisions outside of investments. Decisions ranging from what type of car to buy to which is the best life insurance policy to use are often made by clients only after first consulting their private wealth managers.

In a Nutshell

The wealth management industry integrates the varied and complex business of managing wealth by accounting for income needs, taxes, estate preservation, and asset protection for the wealthy. Typically, private wealth management is a smaller division of a much larger investment firm or bank. The private wealth manager leverages the expertise of the various departments inside the firm (such as the trust department) to present clients with solutions to wealth management issues. Though not required to be experts in one particular area of wealth management, private wealth managers must know enough about each area to expertly represent their clients’ best interests and, where appropriate, offer advice.

Other Services Provide by Wealth Managers

Some firms offer other unique services, which vary from firm to firm. Some of these might include:

• Philanthropic services: Giving to charities in a planned way.
• Agricultural services: The transfer and/or management of farms or ranches for families.
• Auction and art services: Providing services allowing clients to purchase, value, sell, and manage collections of fine art.
• Appraisal services: Valuing and managing unique assets like intellectual property.
• Securitization services: Providing ways to monetize any assets that provide a stream of cash flow, like movie or book royalties.

Investment Products

In addition to providing services to clients, private wealth managers also offer investment products that provide capital growth, income, or both. One class of investment products, options, can be used to both provide income and manage risk.

Equity Investments

Common stock is the best known type of investment. Each share in a company, such as Starbucks, for example, represents a small percentage of ownership. The major advantage in owning common stock is that it can be bought or sold without difficulty, making it easy to convert ownership into cash. Also, as a stock’s price grows, the increased value is tax-deferred until it is sold. The profit a client makes when the stock is sold is usually taxed at a lower rate than regular income. Another advantage is that investors do not have to actively manage anything, as they might if they owned other types of businesses like a chain of gas stations or stores, but can rely on professionals to manage their investments for them. One disadvantage is investors need to be very familiar with the company’s operations to constantly gauge whether it is still a good investment.

Equity mutual funds are popular investment vehicles that allow average investors to hire professional money managers. Vanguard is one of the more popular mutual fund companies, and Vanguard U.S. Growth Fund Investor Shares (VWUSX), founded in 1959, is one its oldest funds. Vanguard pools investors’ money and then a professional portfolio manager uses the pool to buy and sell common stock in various companies to increase the fund's value. The fund’s value is determined by adding up all of the stock it owns at the close of business every trading day. That value is then divided by the number of shares outstanding to determine the share price or net asset value. One of the major advantages to shareholders in owning mutual funds is the professional investment management they get by using portfolio managers. They also get diversification of their assets. In addition, investors don’t always have to make the buy and sell decisions in regard to the individual stocks they own. One disadvantage is that mutual funds’ profits can be taxed at a higher rate than that of regular common stock. They also tend to require much more bookkeeping for tax purposes than other types of investments. Some critics feel that since mutual funds attract such large sums of money, over-diversification can be a problem.

Closed end investment companies, also known as closed end funds, are a cross between a mutual fund and common stock. A notable example of closed end fund is Berkshire Hathaway, run by legendary Wall Street wizard Warren Buffet and his colleagues. In short, Berkshire Hathaway’s end product provides an investment return, just like Microsoft’s end product is software. In Berkshire Hathaway, like a mutual fund, investors gather their money into a pool that is then managed by Warren Buffet. Unlike a mutual fund, however, a closed end investment company trades independently of its actual asset value and might end the day with a net asset value of $12 but a share price of $12.50. A mutual fund must sell for its net asset value, but a closed end fund’s share price is determined by whatever price investors pay for it on a trading market, just like Google’s or Chevron’s share price. Closed end companies will often invest in specific industries, such as banking or software, or in specific geographical areas like developing countries or Eastern Europe.

Closed end investment companies tend to be a little more tax efficient and smaller in size than mutual funds, thus easier to manage. Clients pay a regular stock commission to buy these funds, plus a fee to the managers. These expenses are usually higher than those charged by mutual funds.

Unit investment trusts (UITs) are simple investments in either stocks or bonds, and easily recognizable to clients. However, they are generally not as tax-friendly as common stock or even mutual funds. Like mutual funds and closed end funds, these trusts pool investor money. However, UITs use “passive management” of a fixed portfolio of assets or stock, meaning no additional buying and selling in the portfolio. For example, Dow Theory (often referred to as Dogs of the Dow) states that if you buy the 10 highest dividend-yielding stocks in the Dow Jones Industrial Average in January and hold them for one year, you will outperform the market. The theory works modestly well, and because it relies on buying stock in companies well known by the average investor and using a passive investment strategy, Wall Street insiders recognized that if they packaged the strategy inside a UIT they’d have a product popular with investors. UITs are meant to be held until a fixed expiration date, at which point the net asset value is returned to the investor. Although some companies allow investors to sell at the net asset value earlier than the expiration date, every UIT is different and some may need to be held until the expiration date of the underlying trust.

Fixed-Income Investments

Preferred stock is a type of equity with superior rights over common stock in a company. Often, one of these rights is a dividend, which is a fixed percentage of the preferred stock’s par value (the original value for which the stock was issued). For example, GM may have a preferred stock that pays a 5 percent dividend on a $25 par value, meaning it pays 5 percent of $25. When a preferred issue has dividends attached to it, the company distributes these to preferred shareholders before giving any to common stockholders. The rights to these dividends may expire in one year’s time or be cumulative over a period of time. In addition, preferred shareholders have superior claim over common shareholders to the assets of the company in case of liquidation. Preferred shares might also be convertible (known as convertible preferred stock) into shares of common stock in lieu of dividend payments. Dividends are generally paid on a quarterly basis. The cash flow created by preferred stock is often attractive to investors looking for income and preferred stock offers some opportunity for growth. It can be a good option for conservative clients looking for maximum cash return and modest growth. The downside for investors is that dividends are taxed as ordinary income, and the growth potential is often negligible.

Bonds are notes issued in $1,000 increments (called the par value or principal) that pay a stated rate of interest (called the coupon rate) and require the debtor to return the principal, or par value, back to the investor at a specified time (called maturity). Generally, bonds are issued for periods of one, two, five, 10, 20, and 30 years. Longer periods carry higher interest rates than shorter periods. As prevailing interest rates go up or down, bonds trade for either more or less than their par value to reflect the going market interest rates. Let’s say that 30-year corporate interest rates are now 5 percent. A corporate bond that was issued last year that carried a coupon rate of 4.8 percent would now trade at 96 (that is, 96 percent of par value) or $960. Interest rates and bond values have an inverse relationship. As interest rates go up, bond values go down. As interest rates go down, bond values go up. Bonds may be callable—meaning the issuer can “call” it back and give an investor back his or her principal—after a period of time as well. Thus, if interest rates go down too much, the issuer will call the bonds back, returning the par value to investors because they can issue other bonds to replace these at lower interest rates. Bonds may be backed by specific assets or revenue, or may be completely unsecured. They may be convertible to shares of common stock as well. Bonds are often used in loans to secure real estate purchases since the value of the land can secure investors’ money. The three types of major bonds are corporate, treasury, and municipal, and each carries different risk factors with different tax rates.

Corporate bonds provide the highest rate of interest out of the three major classes. They also hold the most risk. Interest rates for bonds are determined by the length to maturity (when the investor will get his or her money back), the assets or lack thereof that back up the bonds, and the credit rating of the offering company. Several firms, such as Standards & Poor’s, Moody’s, and Fitch Ratings, analyze the creditworthiness of issuing companies and provide ratings that grade bonds’ quality on the investors’ expectation of getting their money back. These ratings vary from high-quality investment grade bonds (most likely to get their money back), to lesser bonds called junk bonds (less likely to get their money back), to distressed bonds (fat chance of getting any money back) that are in default on payments to investors.

Corporate bonds are generally taxed at a higher rate than other types, which means that corporations must offer higher interest rates so investors retain the same amount of money after paying taxes as they would if they had invested in lower taxed bonds. The amount of money kept after paying taxes is called the after-tax yield.

Advantages provided by corporate bonds include relatively high interest rates, the availability of investment-grade bonds, regular interest payments, and investing ease. The downside for bond buyers is that inflation may eat away at after-tax yield. Also, interest rates could go up, and investors would then be stuck with bonds that pay less than the going rate. Another concern is that if interest rates go down, the issuer may call back the bonds, forcing investors to invest at the prevailing lower interest rates.

Treasury bonds are issued by the federal government and are often considered one of the safest investments. After all, to pay off the bonds, the government only needs to raise taxes. Because Treasuries are backed by the full faith and credit of the U.S. (as well as its taxing power), they enjoy unrivaled prestige in world finance today.

Treasuries are issued in three-month, six-month, two-year, three-year, five- year, seven-year, 10-year, 20-year, and 30-year maturities. Economists and investors look at the differences in interest rates in the range of maturities in Treasury bonds to get an idea of where the economy is headed. This range is called the spread. A tighter or smaller spread, it is often claimed, can forecast uncertain economic activity. Because Treasuries are not considered as risky, they have lower interest rates than other types of bonds. However, Treasuries are subject to the two types of risk discussed previously: inflation, and the possibility that interest rates will go up.

Municipal bonds are issued by cities, states, counties, and other non-federal government entities. In accordance with United States Supreme Court ruling, municipal bonds, or munis, are free from federal taxation in most cases. Also, municipal bonds may not be subject to state taxes, although regulations vary from state to state. Since municipalities can offer investors the same after-tax yields at lower interest rates as other issuers, bonds are a major advantage for said municipalities, in that they are a less expensive method for raising money. Some types of munis include: general obligation bonds, containing the promise to pay by the municipality as a general obligation; revenue bonds, backed by specific taxes or fees, like money collected on a toll road; and hospital bonds, used to finance the building of public hospitals.

The same agencies that rate corporate bonds on a company’s likelihood to pay also rate munis. Municipalities that exercise responsible fiscal management enjoy a higher rating, and are able to borrow money at lower rates than those not as responsible. Because municipalities can rely on tax revenue to repay investors, like the federal government does, munis are generally considered somewhat less risky than corporate bonds, depending on the issue. However, municipal bonds are also subject to the same two types of risk previously discussed in relation to bonds: inflation, and the possibility that interest rates will go up.

Bond mutual funds function just like equity mutual funds, but invest in bonds and pass along interest payments to their investors. The benefit to investors is in having professionals manage a diversified portfolio of bonds. The disadvantage is that bond funds are not as tax efficient. Bonds are generally not meant to be bought and sold but are often included in a fund. This means that capital gains are passed along to investors, who then have to pay taxes on the gains. Also, investors don’t benefit from a maturity date at which time their principal will be returned, which they would if they owned individual bonds. Lastly, a portfolio of individual bonds does not charge investors a management fee, which reduces the amount of return, as a bond fund does.

Closed end bond funds are also very similar to their equity brother, the closed end investment company, except that they invest in, yes, bonds. Again, these funds don’t promise to return principal, like a single bond would, although investors do receive professional management.

Real estate investment trusts (REITs) are investment companies that invest in real estate properties and mortgages. Under IRS regulations, REITs are required to pass along at least 90 percent of their taxable income to their investors. Accordingly, REITs often pay higher income yields than bonds, and when real estate markets rise, the share prices of REITs also tend to go up. On the downside, real estate markets can be hard to predict, and are sometimes forecast on interest rates and other general economic factors that make them a challenge to manage, even for experienced real estate managers. And when real estate markets are bad, they often stay that way for longer periods of time than other parts of the economy. REIT.com reports that there are more than 225 REITs registered with the Securities and Exchange Commission that trade on one of the major stock exchanges—the majority on the New York Stock Exchange. These REITs have a combined equity market capitalization of more than $1 trillion.

Products Requiring Accreditation

These products can only be sold to clients meeting certain income or net worth criteria. According to the Securities and Exchange Commission, these include individuals with a net worth in excess of $1 million; a person with income in each of the last two years of at least $200,000 ($300,000 when combined with a spouse); and a trust with assets topping $5 million.

Hedge funds are becoming an increasingly popular investment alternative for the wealthy because they can take advantage of investment techniques not always available to mutual funds and other portfolio managers, like short sales that can lower the amount of risk for investment portfolios. This is especially important during periods of volatility, such as what we have experienced over the past few years. A short sale occurs when an investor borrows stock and sells it in the open market, anticipating that the price will go down and he or she will be able to buy it back at a lower price. Using this technique, hedge fund managers are able to make money for clients regardless of the overall direction of the stock market. If the market goes up, clients make money; if the market goes down, clients make money. (That is, if the hedge fund manager is good.)

One of the concerns in the hedge fund industry, however, is the lack of regulation, which could hurt investor confidence if more people with less experience are drawn to the industry just because it happens to be hot. Another drawback is the relative lack of liquidity. Unlike mutual funds, which require investors to liquidate their shares at the end of the business day when requested, hedge funds can take as long as 30 days to liquidate investor holdings.

Private equity funds invest in companies in anticipation of taking them public. A private equity firm will often have an investment banking department that provides investors with the opportunity to invest in companies prior to going public. Because, at this stage, companies are generally rising in value, this can prove to be a very good strategy for investors. However, these investments are generally illiquid, require a time horizon of more than two years and contain a degree of risk and sophistication not found in the common wealthy investor.

Private portfolio management involves wealthy clients having portfolio managers to actively manage their investments in the same manner as a mutual fund manager, but instead of owning shares in the fund, the clients own a regular portfolio of common stock. This strategy is more tax efficient than others, and provides a degree of diversification. Often, clients enjoy the personal service they receive in this arrangement, though it is a little more expensive than some other strategies.