The Wealthy More Exposed This Time

An interesting report in the weekend Wall Street Journal, “A Risky Profile,” by Robert Frank, argues that the very wealthy (ah, our favorite top 1%) have taken on more risk and therefore were likely, as a group, to have taken a bigger hit last weak than the wealthy of the past.

Now in a way, this is seriously good news. Someone had to be buying all those crazy risky instruments. Frank tells us the rich were participants, and in addition, were also bigger users of leverage than heretofore. Otherwise, it would all be in the hands of pension funds, endowments, insurance companies, and other financial institutions. Glad to know the rich are pulling their weight.

The uber-wealthy were always the preferred targets for hedge funds. But in the last few years, institutional investors have been piling in with both feet. So the more interesting question, which Frank’s piece doesn’t answer (and in fairness, it may be well nigh impossible to develop the data) is who is holding the risky assets, and in what proportion to their total net assets? That will tell you how seriously exposed various types of investors truly are.

But institutional investors are relative return investors. If markets go down, oh well, that’s too bad, but what they care about it how they performed relative to a benchmark. The wealthy are absolute return investors. Losses bother them more than the pros. So the other interesting question is how this will affect the consumption patterns of the wealthy. Presumably, we’ll see weaker art auction prices and less demand for high end real estate, particularly vacation properties (note these are typically lagging indicators, so they may not weaken for a while). How much it will affect routine luxury good sales is an open question.

Please take note of one factiod. The story mentions that, “The nation’s richest 1% controlled 51% of the country’s individually held stocks in 2004, the latest period measured. That was up from 41% in 1989.” That seems to support the idea that income and wealth disparity are increasing, a fact bitterly disputed by Alan Reynolds (see here and here for some examples).

From Frank:

Today’s rich have expanded their fortunes and lifestyles in large part by turning to highly risky investments. In the search for ever-higher returns, they’ve doubled their holdings in hedge funds and other “alternative investments,” and poured their money into stocks while draining down cash. At the same time, they’ve dramatically increased their debt.

“The wealthy have taken on much more risk than they had 10 or 20 years ago,” says Steve Henningsen, a partner at Wealth Conservancy, a Colorado wealth-management firm. “They’re probably more exposed to more risk than the average investor because they’ve been the ones buying all these fancy debt products, hedge funds and other investments that their advisers told them to buy.”….

Consider stocks. The nation’s richest 1% controlled 51% of the country’s individually held stocks in 2004, the latest period measured. That was up from 41% in 1989…

In 2002, the last time markets fell significantly, financial millionaires — or those with at least $1 million in investable assets — lost $200 billion of their total wealth of $7.6 trillion. That represented 2% of their wealth. Yet today, they’re exposed to risks far less understood than stocks or bonds.

Since 2002, financial millionaires have more than doubled their exposure to hedge funds, private equity and other so-called alternative investments, according to Merrill Lynch and Cap Gemini. (Those investments now make up more than 20% of their portfolio.) They also have increased their exposure to stocks by 55%. Meantime, they’ve cut their holdings of cash and bonds, the two most stable investments. Their exposure to real-estate has stayed the same.

Today’s wealthy also rely more on borrowed money. The nation’s richest 5% held $1.67 trillion in debt, up fourfold from 1989. A large part of that is mortgage debt, but wealth experts say some of the funds have also gone into risky and higher-yielding investments, such as hedge funds. Since hedge-funds themselves are highly leveraged, the double-borrowing could make for a rapid fall should hedge funds start to implode.

While the rich employ sophisticated advisers, sometimes they don’t steer their clients to the safest investments. “A lot of the wealthy have leveraged up their house to put money into hedge funds or do the Japan carry-trade because they could make more than their costs of borrowing,” Mr. Henningsen said. “That desire for yield could come back to haunt them.”

Granted, some rich investors have started to pare back their risk, anticipating a downturn….On the whole, however, advisers said most clients are staying put.

At the same time, the appetite for risk among the wealthy for even more exotic markets — such as wine, art and other collectibles — shows no sign of slowing. On Wednesday, the day after the Dow plunge, Sotheby’s auctioned off bottles of wine from the private cellar of Baroness Philippine de Rothschild. The auction fetched $2.2 million — more than double the estimate.