Investment Counsel For Private Clients 1993 Peavy

ICFA Continuing Education
Investment Counsel for Private Clients

October 8-9,1992
Chicago, Illinois
Charlotte Beyer
Jean L.P. Brunet CFA
Dwight D. Churchill, CFA
Peter Davis
George D. Friedlander
Frank E. Helsom, CFA
Warren N. Koontz, Jr., CFA
William R. Levy
David L. Mead, CFA

H. Scott Miller
Brian A. Murdock
John W. Peavy III, CFA
Nancy C. Smith, CFA, Moderator
Diane M. SpirandeIli, CFA
R. Gregg Stone
Edited by John W. Peavy III, CFA
AIMR Education Steering Committee 1992-93

James R. Vertin, CFA, Co-Chairman
Menlo Park, California
Charles F. O'Connell, CFA

Chicago, Illinois
Ian R. O'Reilly, CFA, Co-Chairman

Toronto, Ontario, Canada
Donald L. Tuttle, CFA

Charlottesville, Virginia
Charles D. Ellis, CFA

Greenwich, Connecticut
Eliot P. Williams, CFA

Hartford, Connecticut
Lea B. Hansen, CFA

Arnold S. Wood
Boston, Massachusetts
Susan D. Martin, CFA

Hudson, Ohio
The Association for Investment Management and Research

comprises the Institute of Chartered Financial Analysts and the
Financial Analysts Federation.
1993, Association for Investment Management and
Research
All rights reserved. No part of this publication may be
reproduced, stored in a retrieval system, or transmitted, in any
form or by any means, electronic, mechanical, photocopying,
recording, or otherwise, without the prior written permission
of the copyright holder.
This publication is designed to provide accurate and
authoritative information in regard to the subject matter
covered. It is sold with the understanding that the publisher
is not engaged in rendering legal, accounting, or other
professional service. If legal advice or other expert assistance
is required, the services of a competent professional should be
sought.
From a Declaration of Principles jointly adopted by a Committee of

the American Bar Association and a Committee of Publishers.
ISBN-10: 1-879087-22-7 ISBN-13: 978-1-879087-22-4
Printed in the United States of America

4/1/93
Table of Contents
Foreword
iv
Katrina F. Sherrerd, CFA
Biographies of Speakers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Investment Counsel for Private Clients-An OveNiew

John W. Peavy ill, CFA . . . . . . . . . . . . .
Understanding Private Client Characteristics

Charlotte Beyer. . . . . . . . . .
Investment Planning for Entrepreneurs

Peter Davis. . . . . . . . . . . .
11
Investment Planning for Wealthy Families

H. Scott Miller . . . . . . .
15
Asset Allocation for Private Clients

Jean L.P. Bnmel, CFA . . . .
18
SeNicing the Private Client-Part I

Brian A. Murdock
.
25
SeNicing the Private Client-Part II

David L. Mead, CFA . . . . .
29
The Value of SpecialiZed Investment SeNices

Frank E. Helsom, CFA . . . . . . . . .
37
Investing in Municipal Bonds for Private Clients

George D. Friedlander . . . . . . . . .
45
Investing in Venture Capital for Private Clients

R Gregg Stone . . . . . . . . . .
51
International Investing for Private Clients

Diane M. Spirandelli, CFA . . . .
58
Understanding the Tax Constraints on Private Clients

Warren N. Koontz, Jr., CFA . .
.
65
(continued on next page)
Estate Planning and Charitable Giving for Private Clients

William R Levy
.. . . . . . . . . . . . . . . .
72
Portfolio Management for Private Client&-A Case Study

JolmW.PeavyIII,CFA
81
Applying the AIMR Performance Presentation Standards to Private Clients

Dwight D. Churchill, CFA. . . . . . . . . . . . . . . . . . . . . .
87
Self-Evaluation Examination
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..
94
98
ICFA Board of Trustees,

Ian R. O'Reilly, CFA, Chairman
Eliot P. Williams, CFA, Vice Chairman
Hartford, Connecticut
Darwin M. Bayston, CFA, President and
Chief Executive Officer
Frederick L. Muller, CFA, AIMR Chairman
Atlanta, Georgia
Charles D. Ellis, CFA, AIMR Vice Chairman
James K. Dunton, CFA
Los Angeles, California
Thomas L. Hansberger, CFA

Ft. Lauderdale, Florida
Lea B. Hansen, CFA
Norton H. Reamer, CFA
Eugene C. Sit, CFA
Minneapolis, Minnesota
Eugene H. Vaughan, Jr., CFA
Houston, Texas
Brian F. Wruble, CFA
Philadelphia, Pennsylvania
AIMR Council on Education and Research

James R. Vertin, CFA, Chairman
Menlo Park, California
Keith P. Ambachtsheer
Darwin M. Bayston, CFA
Gary P. Brinson, CFA
Chicago, Illinois
Charles D. Ellis, CFA
H. Russell Fogler
Gainesville, Florida
W. Van Harlow III, CFA
Lawrence E. Harris
Los Angeles, California
Martin L. Leibowitz
New York, New York
Roger F. Murray
Wolfeboro, New Hampshire
Ian R. O'Reilly, CFA
Dallas, Texas
Andre F. Perold
Frank K. Reilly, CFA
Notre Dame, Indiana
Stephen A. Ross
New Haven, Connecticut
William F. Sharpe
Los Altos, California
Eugene C. Sit, CFA
Minneapolis, Minnesota
Bruno Solnik
Paris, France
Staff Officers
Darwin M. Bayston, CFA
President and Chief Executive Officer
Thomas A. Bowman, CFA
Executive Vice President
Michael S. Caccese
Senior Vice President and General Counsel
Senior Vice President
Donald L. Tuttle, CFA
Randall S. Billingsley, CFA
Vice President
Raymond J. DeAngelo
Vice President
Julia S. Hammond, CFA
Vice President
Robert M. Luck, CFA, CPA

Vice President
Peggy M. Slaughter
Vice President
Roger L. Blatty
Assistant Vice President
Moira C. Bourgeois
Joy N. Hilton
Dorothy C. Kelly
Jane P. Birckhead, CPA
Treasurer and Controller
Foreword
Servicing the investment needs of high-net-worth
individuals and their families-so-called private clients-requires a combination of technical skill and
diplomatic acumen. This is because such clients
often expect more from their investment advisor than
"just" investment performance.
Although the process of managing money is basically the same for individuals and institutionsboth must be dealt with on the basis of their unique
needs and characteristics-significant differences
nevertheless exist. For one, dealing with private clients can be complicated by a family's conflicting
objectives involving several different generations.
For another, investment advisors must balance
unique constraints-including an individual's tax
and legal considerations-with investment strategy.
Because of the importance the private client market is assuming in the world of investment management, AIMR sponsored a seminar entitled Investment
Counsel for Private Clients. This proceedings explores
the processes involved in setting long-term goals and
implementing investment strategies for clients who
have substantial assets. The proceedings also addresses ways to educate and communicate with these
special clients.
Many individuals contributed to the success of

Publications and Research
AIMR
iv
the seminar and this proceedings. AIMR wishes to

acknowledge all of them with gratitude. Special
thanks are extended to John W. Peavy III, CFA, who
edited this proceedings with such skill, and Nancy C.
Smith, CFA, who served as conference moderator
and ably guided the discussions in Chicago. Their
advice was instrumental in shaping this publication
and the valuable information it contains.
The speakers contributing to the seminar were:
Charlotte Beyer, Charlotte Beyer Associates; Jean L.P.
BruneI, CFA, J.P. Morgan Private Banking Group;
Dwight D. Churchill, CFA, CSI Asset Management,
Inc.; Peter Davis, Wharton School, University of
Pennsylvania; George D. Friedlander, Smith Barney,
Harris Upham & Company; Frank E. Helsom, CFA,
University Investment Management, Inc.; Warren N.
Koontz, Jr., CFA, The Jeffrey Company; William R.
Levy, The Glenmede Trust Company; David L.
Mead, CFA, Harris Trust and Savings Bank; H. Scott
Miller, Miller, Anderson & Sherrerd; Brian A. Murdock, Merrill Lynch Asset Management; John W.
Peavy III, CFA, Southern Methodist University;
Nancy C. Smith, CFA, The Glenmede Trust Company; Diane M. Spirandelli, CFA, Swiss Bank Corporation; and R. Gregg Stone, PR Venture Partners L.P.
and Pell, Rudman & Company, Inc.
Biographies of Speakers
Charlotte Beyer is founder and president of Charlotte Beyer Associates, a consulting firm focusing on
the high-net-worth-individual market. Previously,
Ms. Beyer directed private client marketing for
Lazard Freres Asset Management. She also was senior vice president and principal of Wood, Struthers
& Winthrop and vice president in the Fiduciary Department at Bankers Trust Company. She is a trustee
of the Westover School in Middlebury, Connecticut.
Ms. Beyer graduated from Hunter College and attended the University of Pennsylvania and the New
York University Graduate School of Business Administration.
Jean L.P. Brunei, CFA, is managing director and
chief investment officer of the J.P. Morgan Private
Banking Group. Previously, he was head of J.P. Morgan Investment Management Australia Ltd. and J.P.
Morgan Investment Management Singapore. Mr.
BruneI began his career at J.P. Morgan as a research
analyst and has worked in New York, Tokyo, and
Hong Kong. He is a graduate of the Ecole des Hautes
Etudes Commerciales in Paris and received an
M.B.A. from Northwestern University.
Dwight D. Churchill, CFA, is president of CSI Asset
Management, Inc., a fixed -income and equity investment management unit of Prudential Insurance
Company of America. Previously, Mr. Churchill was
managing director of Prudential Fixec1-Income Advisors. He also was vice president and portfolio manager at Loomis Sayles & Company in Detroit and
bond portfolio manager for the Public Employees
Retirement System of Ohio. Mr. Churchill serves on
the Candidate Curriculum Committee of the Institute
of Chartered Financial Analysts and on the AIMR
Performance Presentation Standards Implementation Committee. He holds a B.A. from Denison University and an M.B.A. from Ohio State University.
Peter Davis is director of family business executive
education programs at the Wharton School, University of Pennsylvania. He founded the family business programs at Wharton, the first of their kind at a
US. university. He has worked as a consultant and
advisor to many family businesses and family offices,
and he specializes in issues attendant to the management of change and succession in family organizations. Mr. Davis is a columnist for and chief advisor
to Family Business Magazine as well as an editor of
Family Business Review and a series editor for the

Jossey Bass Family Business Series. Mr. Davis was educated at Cambridge University, the London School
of Economics, and the Wharton School.
George D. Friedlander is managing director of the
High Net Worth/Retail System at Smith Barney,
Harris Upham & Company. He has more than 17
years' experience in municipal credit and market
analysis and includes taxable fixed-income securities
in his market/portfolio strategy work. Mr. Friedlander is a member of the Public Securities
Association's Municipal Division Executive Committee. He was voted All-American Municipal Portfolio Strategist by the Global Guarantee newsletter and
was named to the All-American Research Team by
Institutional Investor magazine. Mr. Friedlander received a BS. in mathematics from the State University of New York at Stony Brook and an M.B.A. in
finance from Pace University.
Frank E. Helsom, CFA, is chairman and chief investment officer of Uni versity Investment Management,
Inc., a subsidiary of Templeton Portfolio Advisory,
Inc. Mr. Helsom is a former president and current
vice chairman of Templeton Investment Counsel,
Inc., which provides account management to large
institutional investors. Previously, as a research analyst and portfolio manager, Mr. Helsom started and
managed the Midwest regional group for Citicorp
Investment Management, Inc., and also held positions in the investment management group at lincoln National Corporation. He has served as
president and member of the board of directors of the
Investment Analysts Society of Chicago. Mr. Helsom
holds degrees from Northwestern University and
Wayne State University.
Warren N. Koontz, Jr., CFA, is vice president and
treasurer of The Jeffrey Company, a private investment firm. His responsibilities include the development and implementation of tax-efficient investment
strategies for internally and externally managed equity portfolios. Previously, he was assistant investment officer for the Public Employees Retirement
System of Ohio, where he managed the equity assets
and staff. He also has been a portfolio manager,
equity security analyst, and fixed income analyst.
Mr. Koontz holds a BS. in finance and an M.B.A.
from Ohio State University.
v
William R. Levy is vice president of The Glenmede

Trust Company, where he administers the Personal
and Institutional Accounts department. Previously,
he was assistant vice president at Provident National
Bank responsible for administration of trusts and
estates. He also served at Fox, Rothschild, O'Brien
and Frankel as an associate attorney specializing in
estate and trust administration and estate planning.
Mr. Levy has lectured for the Pennsylvania Bar Institute and is a faculty member of the Pennsylvania
Bankers Association Central Atlantic School of Trust.
He received a bachelor's degree in urban studies
from Trinity College and a J.D. from Dickinson
School of Law.
David L. Mead, CFA, is vice president and chief investment officer of Harris Trust and Savings Bank,
where he directs the Personal Financial Services department. Mr. Mead is a regular panelist on "Sound
of Business," the bank's nationally circulated
monthly investment cassette series. He is a member
of the Investment Committee of the Corporate fiduciaries of Chicago and the Chicago Society of Financial Analysts. Mr. Mead received B.s. and M.B.A
degrees from the University of Southern California.
H. Scott Miller is portfolio manager at Miller, Anderson & Sherrerd's Private Investor Group. Previously, he was vice president of the investment
banking division of Goldman Sachs & Company and
vice president of the private investor department.
Mr. Miller is a director of Mediq, Inc., and serves as
a trustee for the Gaudino Trust, Williams College.
Mr. Miller received a B.A from Williams College and
an M.B.A from the Wharton School, University of
Pennsylvania.
Brian A. Murdock is vice president and senior portfolio manager for Merrill Lynch Asset Management.
He specializes in global investment management
and is a permanent member of the International
Strategy Committee. He was executive director of
the company's Pacific office, establishing the Hong
Kong regional office and developing global products. Previously, he served as financial consultant at
Merrill Lynch International, serving overseas private
clients. Mr. Murdock is a graduate of Cornell University.
JohnW.Peavylll,CFA, is Mary Jo VaughnRauscher Professor of Financial Investments at
vi
Southern Methodist University. He also is on the

faculty of the school's Southwestern Graduate
School of Banking. Mr. Peavy is research director of
the Research Foundation of the Institute of Chartered
Financial Analysts, vice chairman of ICFA's Candidate Curriculum Committee, and executive editor of
The CFA Digest. He serves on the editorial boards of
the Financial Analysts Journal, Review of Business, and
Economic Research. Mr. Peavy holds a B.B.A from
Southern Methodist University; an M.B.A from the
Wharton School, University of Pennsylvania; and a
Ph.D. from the University of Texas at Arlington.
Nancy C. Smith, CFA, is vice president and portfolio
manager of The Glenmede Trust Company. Previously, she was vice president of the Trust Division
of Provident National Bank. She is a member and
past president of the Financial Analysts of Philadelphia, Inc., a past governor of the Philadelphia Securities Association, and a governor of the Association
for Investment Management and Research. Ms.
Smith is a member of the board of directors of the Bell
Atlantic Mutual Funds and a trustee of the American
Red Cross. She is cochairman of AIMR's Annual
Conference Committee and a member of the board
of the Financial Analysts Seminar. Ms. Smith holds
a B.A from Middlebury College and an M.B.A from
Temple University.
Diane M. Spirandelli, CFA, is vice president of Swiss
Bank Corporation, where she is responsible for the
management and marketing activities of global investment and private banking clients. Previously,
she was with Wells Fargo's Private Banking Division.
She is a member of the San Francisco Security Analysts Society. Ms. Spirandelli is a graduate of the
Oxford College of Technology, Oxford, England, and
the University of Washington's Pacific Coast Banking School.
R. Gregg Stone is a general partner of PR Venture
Partners L.P., a venture fund designed as a private
equity investment vehicle for individuals, families,
and their foundations. Mr. Stone also is a vice president of Pell, Rudman & Company, Inc. He is a
director of two portfolio companies and a member of
the board of advisors of two portfolio funds. Mr.
Stone received AB. and J.D. degrees from Harvard
University.
Investment Counsel for Private

AnOvelView
Mary Jo Vaughn-Rauscher Professor of Financial Investments
Southern Methodist University
In an investment world increasingly dominated by
sophistication found among individual clients. This
discipline allows counselors to focus on the types of
institutional investors, the importance of individual
private clients with whom they are most successful.
investors can sometimes be understated. Nevertheless, individuals control substantial pools of assets
For example, many counselors assume that most
private clients fall into the low-sophistication/lowand have important investment management needs.
control quadrant. In this case, the assets may be
"Private clients" are typified by a rising level of
investment sophistication and higher performance
controlled by a large trust, representing a family
interest without a family spokesperson. Because the
expectations and demands. Beyond this general
client does not desire to have frequent contact with
trend, the characteristics of individual investors and
the counselor, the temptation is to leave the account
the circumstances and opportunities that confront
alone. Beyer cautions that such neglect is dangerous
them are more diverse and complex than for any
because of the legal ramifications and the possibility
other class of investor.
A private client cannot be thrown into a homothat a family member of the next generation will take
a more active interest.
geneous group with a common set of investment
Ignore the changing characteristics of the private
objectives, constraints, and preferences; rather, these
individuals represent a large variety of needs. The
client at your peril. Certainly your competitors will
not ignore them. Responding to change mandates
challenge for an investment counselor is to identify
the continuing education of the private client. The
the private client's needs and to manage the client's
portfolio with those needs in mind. Only by satisfyclient will demand it, and an investment counselor
ing individual client needs can the investment councan survive only by responding to this demand.
selor succeed in this diverse market.
The focus of this seminar was on setting longDeveloping Investment Policies
term goals for wealth building and wealth transfer
Davis relates the investment needs of private clients
and implementing investment strategies for the
who have accumulated substantial wealth to the
many pools of funds an individual may have availphases of the business growth and development life
able, including personal/family funds, retirement
cycle. Each phase has different implications for asset
plan funds, private foundations, and charitable
management. Of obvious importance is an investfunds. Considerable emphasis also was placed on
ment counselor's ability to identify an individual's
how to educate and communicate with private clilife cycle phase and to respond accordingly.
ents.
As individuals accumulate wealth outside their
businesses, they tend to respond differently. The
Private Client Characteristics
deal makers want to take these assets and invest in
high-risk "deals." Wealth managers are concerned
Beyer points out that individuals' objectives change
about the preservation and management of the
as the result of human elements (such as marriage,
wealth they have created. These individuals are the
health, children, employment, and aging) and as the
most receptive to professional money management.
result of institutional factors (such as decisions about
The company men and women continue to devote
asset selection, asset allocation, and market timing).
their time and attention to the business-often to the
Furthermore, individuals' expectations are shaped
neglect of their personal assets.
by experience and outside events.
Beyer presents a framework for understanding
Davis advises that investment counselors must
private client characteristics. Using a variation of
be sensitive to transition issues-that is, the transfer
risk-return quadrants analysis, she suggests an apof wealth from one generation to another. Often the
proach featuring the various degrees of control and
younger generations take a more pragmatic view
toward investing and express interest in risk-return

trade-offs. At the same time, these later generations
may have psychological needs that require nurturing
on the part of the counselor.
Investment Strategy and Asset Allocation
are not all alike, a counselor must respond to each

uniquely. Mead provides a general framework for
classifying private clients into broad groups according to their special needs and preferences; these
groups include the ultrawealthy; the unsophisticated; the high-income, new-money investors; and
entrepreneurs. He advises counselors to keep communicating with their clients, especially during the
tough times.
Helsom contends that counselors must care for
their clients' welfare, help them achieve their stated
goals, and charge a reasonable fee. He discusses the
advantages and disadvantages of the major products
available to individual investors (mutual funds,
commingled funds, and individually managed portfolios). He also addresses the several factors that are
most important in the private client market, pointing
out that these factors are not what most counselors
think they are. For example, most portfolio managers focus on cost and performance; according to
Helsom, however, most private clients place higher
priority on their personal relationships with their
managers.
A wealthy client or family may envision a pool of

assets as a collection of unrelated items. Miller advises investment counselors to take a proactive role
in educating their clients that a portfolio should be
viewed as an integrated whole. Many clients have a
large core holding in a closely held company, real
estate, or some exotic asset. Miller argues that the
counselor's mission should be to recognize that the
core assets are part of an overall portfolio and to
determine how these assets interact with other assets
in the client's portfolio. The first step is to define the
portfolio. Only then can the counselor effectively
proceed to structure it.
Private clients are not a homogeneous group,
according to BruneI. Given their diversity, investment counselors should ask three questions to gain
proper perspective:
Who are these people?
Special Assets for Private Clients
What do they need?
People often think of domestic corporate stocks and
What are they looking for?
bonds as the major components, if not the sole comBy asking these questions, the counselor will
ponents, of individual portfolios. Individuals, howdiscover each client's unique goals and needs. Only
ever,
also need to diversify their holdings. Three
after hearing the answers to these questions and
presentations
describe possible candidates for diveridentifying the client's key characteristics can the
sifying
investments-municipal
bonds, venture capcounselor proceed to make asset allocation recomital,
and
international
investments.
mendations. BruneI advises that a portfolio for a
specific person should reflect four factors-taxability, portfolio context, income needs, and multiple
Municipal Bonds
requirements.
Because of the tax advantages and the huge size
of the municipal bond market (about $1.3 trillion),
Friedlander emphasizes the usefulness of these asservicing the Private Client
sets in private client portfolios. According to Friedlander, knowledge of important supply and demand
Servicing private clients entails a myriad of activities.
factors
is crucial to understanding these securities.
According to Murdock, investment counselors must
In recent years, tax reform has had a substantial
be responsive to the distinctive needs of this special
impact on municipal bonds. As tax rates move up
type of client. Importantly, the private client is not
and
down, so does the demand for municipal bonds.
to be confused with the institutional investor. Murdock discusses the several key traits that differentiate
The growth in ownership by households-and the
virtual disappearance of two former large markets
these types of clients. He emphasizes that with private clients, the relationship is paramount. Mainfor these bonds, namely commercial banks and proptaining successful relationships requires an investerty / casualty insurance companies-also have had
ment counselor to be flexible, demonstrate personala large effect on demand. Other influential factors
ity, communicate proactively, educate clients, show
include the substantial size of new municipal issues
(an estimated $230 billion annually), the extraordiconviction and precision, and of course, make money
for the client.
nary collapse in short-term interest rates, the reducMead maintains that private clients are espetion in existing bond supply because of the calling of
cially sensitive to interpersonal relationships with
many outstanding bonds, the growth of municipal
their investment counselors. Because private clients
bond funds, and the changing yield relationship be2
tween taxable and nontaxable bonds. Friedlander Understanding Legal and Tax Constraints
also delves into other important considerations afKoontz asks, "Why is so little attention paid to the
fecting municipal bonds, including recent credit
effect of taxes on portfolio returns and strategies?"
trends, portfolio considerations, and the current
He contends that by not having much of a "taxable"
market environment.
vocabulary, investment counselors are not best serving their private clients. Koontz's presentation proVenture Capital
vides the incentive to build a better taxable vocabuVenture capital is private equity capital used to
lary and to review investment strategies that can
finance the growth or acquisition of businesses. Acmitigate the tax bite.
cording to Stone, most private investors know little
The capital gains tax, dividend tax, alternative
about venture capital. This is a difficult market in
minimum tax, and state and local taxes all can affect
which to participate because only about 15 advisors
net investment returns. Koontz discusses each in an
control between 60 and 70 percent of the dollars
investment context.
invested in new venture capital opportunities. BeSeveral strategies can help minimize the impact
ginning with the history of venture financing, Stone
of taxes. Among them are semipassive strategies, the
presents information designed to enable counselors
realization of losses, interportfolio swaps, and overto assist their private clients in making informed
lay strategies. Koontz adds that many of these techdecisions about investing in this asset class. For exniques can be used simultaneously to optimize an
ample, venture financing occurs in cycles, and the
individual's tax situation.
pricing and values vary greatly depending on the
phase of the cycle. Stone points out that certain
common characteristics distinguish this asset from Estate Planning and Charitable Giving
the more traditional assets. These features include
The accumulation of large amounts of wealth makes
long-term time horizon, illiquidity, pay-off through
estate planning and charitable giving a necessity for
capital appreciation, and gradual call and return of
the private client. A successful counselor must be
capital. He cautions that venture capital investing is
responsive to these needs. Levy discusses three asnot suitable for every investor; accordingly, investpects of estate planning and charitable giving: estate
ment counselors should provide their clients with
planning
tools designed to reduce or defer tax liabilsufficient knowledge before recommending this type
ity,
methods
for creating pools of funds using lifeof investment.
time gifts to avoid tax liability, and ways to establish
charitable trusts to provide benefits both to the donor
Intemationallnvestments
and to the charity.
Spirandelli comments that international investLevy offers a case study to illustrate specific
ing is often described as nontraditional, but this is a
ways to benefit from estate planning. These benefits
misnomer. Given that the comfort level with interderive from the use of some combination of four
national investing is not very high, Spirandelli sumweapons against estate taxes:
marizes the key challenges confronting investment
The unified credit exemption that procounselors to domestic private clients, including edtects transfers up to $600,000.
ucating them on the benefits of diversifying internaThe unlimited marital deduction that altionally, determining the most suitable global investlows for tax-exempt transfers between
ment approach, and satisfying the special needs of
spouses.
US. clients with respect to foreign investing. She
The annual gift tax exemption that percontends that, with few exceptions, all investors
mits any individual to pass up to $10,000
should hold some assets in this important group.
to another individual tax-free.
The charitable deduction, which can be
The most appropriate international exposure for any
given client's portfolio depends on that client's risk
used to reduce estate taxes.
tolerance level and preferences. As an illustration,
Lifetime gifts also can serve as effective estate tax
Spirandelli provides asset mix suggestions for four
weapons. In particular, the $10,000 annual exclusion
different types of private clients, ranging from a conallows for tax-free transfers. In addition, the use of
servative investor to a more aggressive one. She
split-interest trusts can provide the opportunity to
concludes by encouraging private investment in inleverage a gift. Levy also discusses the tax advanternational assets. The challenges there are real, but
tages of charitable giving through such alternatives
not insurmountable, and the client is likely to be
as outright gifts of cash or properties, split-interest
pleased with the results over time.
charitable trusts, and private foundations.
3
Case Study in Asset Allocation

In recognition that each private client is unique, seminar participants were asked to address five specific
case studies, each designed to provide a "hands-on"
example of portfolio construction for a private client.
These exercises review the entire portfolio management process-an integrated, consistent set of steps
by which a counselor creates and maintains appropriate combinations of investment assets. The
Ramez family case and corresponding guideline answer is reproduced in these proceedings to illustrate
the use of the portfolio management process to arrive
at the best recommendation for a specific client's
needs and objectives.
The case emphasizes the importance of the portfolio management process, beginning with the creation of an investment policy statement. The policy
statement identifies crucial issues pertaining to investor objectives, constraints, and preferences. The
next step is to formulate appropriate investment
strategies and then implement them by selecting the
optimal combination of assets. The case study also
reveals the importance of monitoring market conditions, asset values, and the individual's circumstances and adjusting the portfolio to reflect significant changes in any of the relevant factors.
Performance Presentation
Churchill observes that the AIMR Performance Presentation Standards are the first major initiative to try
to achieve consistency and full disclosure in the way
investment managers report their performance results. The emphasis is on performance presentation
rather than performance measurement. Considerable
flexibility exists in the calculation of results; however, less flexibility occurs in the presentation of the
results.
To comply with the standards, a manager must
subscribe to and follow certain mandatory requirements and make certain mandatory disclosures. At
the forefront of the mandatory requirements is the
performance composite, which is the aggregation of

the performances of several portfolios into a single
number designed to be representative of a particular
strategy. All actual, fee-paying, discretionary portfolios for a particular strategy must be included in a
composite. The performance of a "representative"
account can be presented only as supplemental information. The standards impose other mandatory
requirements as well. Results must be calculated
using a time-weighted rate of return using a minimum of quarterly valuation (monthly preferred) and
geometric linking of period returns. Within a composite, the portfolios must be weighted by account
size. Annual returns must be presented at a minimum for all years. Finally, the inclusion of cash and
cash equivalents in composite returns is required.
The standards specify that certain mandatory
disclosures be provided as supplemental information to the composite. These disclosures cover a
multitude of topics and are designed to clarify the
presentation of results. Finally, the standards discuss verification of results and risk measurement
issues. Churchill concludes that the standards exist
to provide better communication of results, better
understanding of results, and full disclosure about
how results are computed.
A seminar Theme
A common thread among the presentations in this
proceedings is that private clients come in all shapes
and forms. Each client is different and has unique
objectives, needs, and preferences. To be successful
in this dynamic market, investment counselors must
be able to identify and respond to the diverse needs
of these clients. To focus solely on performance is not
enough. Private clients expect and demand more.
These presentations offer valuable information
on how best to work with private clients. Clearly,
this market is substantial and ever-changing-a
combination that offers meaningful opportunities to
responsive investment counselors.
Understanding Private Client Characteristics

Charlotte Beyer
President
Charlotte Beyer Associates
The characteristics and expectations of private clients are always changing, and the truths
that applied to this market yesterday are only myths today. Advisors need to tailor their
methods of approaching and servicing these clients to each client's current needs and
perspectives.
Today's private clients are different from

yesterday's, and tomorrow's will differ even more.
Today's clients are far more sophisticated. They are
willing to shop for-and expect more from-an investment manager.
Myths of the High-Net-Worth Marketplace

Many notions of the private investor are really myths
that should be discarded. Managers who still embrace these old beliefs wi11lose prospects and clients
to those managers who understand today's private
client.
Myth 1: Performance is not important. I have
yet to hear anyone say he or she hired a manager
despite the manager's questionable investment track
record. Private clients want advisors to do a good
job, and that means performance. Of course, good
performance for one client may not be good performance for another. Good performance should be
defined in terms of time frames, inflation, willingness to lose money in a given year or quarter, and
particularly tax sensitivity. Yet few advisors ask clients about these parameters. Clients want to beat the
S&P 500, but how will they feel if the S&P 500 is down
12 percent and the advisor beats the S&P 500 by being
down 7 percent?
Some advisors pick a point on the efficient frontier to identify their clients' risk tolerance. That is like
taking driving classes but never leaving the classroom to drive on the road. One way to get at their
actual risk tolerance is to layout each scenario precisely, perhaps using a matrix to show real dollars
gained or lost in varying market conditions and with
varying asset allocation mixes. This is how you discover a client's real comfort level. Why do so few
managers do this? Because most believe they do not

have to.
Myth 2: The private client market is less competitive than the institutional market. The high-net-worth
market is far more competitive than anybody ever
imagined. The United States has more than 20,000
registered investment advisors today, compared
with fewer than 6,000 in 1980. Many of the 80,000plus brokers in the United States sell exactly what the
advisors do-peace of mind that comes from knowing an expert is interested in and capable of managing a client's assets. Brokers are teaching clients the
meaning of words like "risk-return trade-off" and
"benchmarks." Many advisors are not doing this,
however, because they believe client education is
unnecessary.
Myth 3: The private client market is not as
demanding as the institutional market. Consider the
following example of the demands encountered in
the high-net-worth market: Three investment firms
were asked to make a presentation to a couple who
had recently established a charitable remainder annuity trust with a 10 percent payout (in a 3 percent
interest rate environment) that had been drawn up
by a trusted personal advisor to the family, an accountant/attorney. Should the investment advisors
mention the unrealistic payout? Should they describe the risk of meeting such a payout or merely
explain how they would manage that portfolio with
that goal in mind?
Myth 4: Service is more important than anything else. If an advisor clings to this idea, the organization is probably burdened with too many people
responding to too many unreasonable and irrational
requests. Many advisors believe they must spend a
lot of time talking with their clients, entertaining
5
them, and asking about the children or the summer

houses. They do not spend enough time uncovering
specific investment objectives.
Myth 5: The private client market is unsophisticated. Few advisors realize how sophisticated the
private client has become. The pension industry has
a common language-risk, return, volatility, variability, portfolio characteristics, and so forth. Advisors to private clients seldom bother to explain these
terms to their clients because they assume their clients are not interested in all this. Even if they are not
interested today, they will be soon. One day, an
accountant or attorney will ask, "What benchmark
should we use to evaluate your performance?"
Few investment firms place genuine emphasis
on (and even fewer insist on) a specific and complete
investment policy document. Sophisticated private
clients now demand it, and the less sophisticated will
benefit from it. The client and advisor can avoid the
constant tinkering with the portfolio, for which the
advisor may end up getting fired because he listened
too well to the client. Included in this document are
investment objectives, benchmarks, investment constraints, and guidelines. Within what range of asset
allocation should the manager stay? Does the client
want fully invested positions, or is the allocation to
cash left to the discretion of the manager? How often
will portfolio evaluation take place? What if the
first-quarter performance is dismal? What if the first
year's performance is dismal?
Myth 6: Risk tolerance and other investor characteristics change as asset size changes. A more crucial
factor than asset size is investor personality. You
need to know a client's personality more urgently
than you need to know the size of the assets or how
he made the money.
Myth 7: The private client market is just like the
ERISA market in the early 1970s. The individual market is not like the institutional market of the early
1970s, when the Employee Retirement Income Security Act (ERISA) was enacted. At that time, the institutional market had actuarial or pension consultants
who guided plan sponsors in various investment
directions. They held the sponsor's hand in those
early days when sponsors were not very sophisticated and were just learning. No such organized or
well-informed profession exists today to guide the
private client, but brokers, accountants, attorneys,
and financial planners are all scrambling to learn as
much as they can about asset management. The role
of the intermediary in the private investor market is
evolving at breakneck speed.
Recent Developments
The returns of the 1980s were staggering and created
a dramatically different environment for advisors.
Private clients now expect 12 or 13 percent annual
returns for a balanced fund and 25 or even 40 percent
as a reasonable annual stock market return. Many
people remember only recent history, so an advisor
has the formidable task of being a historian. Events
such as marriage, health, aging, and shifts in the
economy all have an impact on the psyche and,
ultimately, on client expectations, which are crucial.
Brokers' wrap fees are the single greatest change
to occur in the marketplace. Forbes magazine may
call them "rip fees," but the wrap fee business is
exploding. Hundreds of new accounts are being
opened daily by virtually every brokerage firm
across the United States, and the pace shows no signs
of slowing. Brokers are counseling on investment
objectives, time horizons, and risk tolerance. The
more skilled the brokers become, the bigger threat
they are to the investment management business,
unless the manager is in one of their programs or is
a superior counselor.
Another change is the spotlight press attention.
Magazines as varied as Town & Country and Vogue
have articles on managing personal finances. Every
day, the Wall Street Journal and other periodicals have
score cards on mutual funds. They carry contests for
investment advisors and articles on how to pick a
money manager. A private client cannot escape
these articles. As Emerson aptly said, "A little
knowledge is a dangerous thing." This is our
challenge.
The growth in awareness has led to a more sophisticated market with a continuing thirst to learn
more. Not too long ago, people did not even talk
about money. Next month, more than 250 private
investors will assemble in New York for the Chase
Global Forum. Throughout the year, Northern Trust
hosts family financial forums. Harris Trust has been
doing this for years. The Institute for Private Investors, a membership group, was a sellout in its very
first year. When T. Rowe Price placed a small advertisement for a retirement planning kit, it broke industry advertising records for the percentage who responded and then bought one of its funds.
What do all these private clients seek? They
want to improve their understanding of the investment issues facing them. The most important topic
to the membership of the Institute for Private Investors is aftertax returns. Warren Koontz presents some
astonishing research on the impact of turnover on
aftertax returns. 1 This is a major issue right now.

More investors today are capable of distinguishing
their different pools of capital, and they expect their
advisors to respond accordingly. Fidelity recently
introduced a charitable gift fund that has already
attracted $10 million with about a 2 percent fee, and
it has not even started marketing it.
Individual objectives change every day, and so
do the pools of capital. How many people 20 years
ago knew anything about defined-contribution
plans? Today, many clients and prospects not only
are participants in such a plan but also think about
which fund to try and whether they should try to
time the market. This is an enormous change and a
very different pool of capital than many advisors are
used to working with.
One more change is the number of clients involved in philanthropy. If they are appointed to a
hospital board or a museum board, suddenly two
new pools of capital are created-not only the
museum's or hospital's endowment but possibly
also a pooled-income gift to that museum or hospital.
Who can keep up with all of this? You will, if you are
the investment counselor.
Working with the Private Client

Not every excellent investment advisor is a good
counselor. An honest acknowledgment of your own
skill might point you toward working with intermediaries who perform the counseling and leave the
portfolio management to you. Successful firms are
figuring this out and adjusting their public contacts
accordingly. Whether you are more comfortable as
a manager or a counselor, you must understand the
characteristics of the private client market.
I am often asked, "What is the secret to this
market?" I believe there is no secret-and that is the
secret. Success comes to those who analyze most
astutely what is occurring in the "process" of working with prospects and clients. By accurately analyzing private clients, advisors do a better job of attracting the right client for their firms, and they keep the
clients they have.
The four quadrants in Figure 1 illustrate a framework for understanding private client characteristics. It is a variation on the risk-return quadrants.
The x-axis is a continuum of control. How much
control does the individual currently want to exert
with an investment manager? This changes over
time and can change dramatically between the beginning of a client-advisor relationship and the end of
the first year. The y-axis is a continuum of sophistilSee Mr. Koontz's presentation, pp. 65-70.
cation, or level of investment education or experience. By accurately analyzing clients, advisors will
not waste time but will focus on the types of private
clients with whom they are most successful. Are you
poor at educating? Are you impatient with clients
who need to control, at least initially? Are you hesitant to address delicate family issues and confrontations?
The low-sophistication-high-control quadrant
in the lower right panel of Figure 1 is where many of
the most frustrating prospects fall-the family with
one holding of low-cost stock, for example. To quote
one manager, "I have tried for five years to teach this
family group the importance of diversification but
with no success." This is where other pools of capital
come in, smaller pools-trusts for grandchildren or
private foundations. Client education is easier when
working on a smaller trust or a foundation. The need
for tight control (motivated no doubt by fear) is less
because of the smaller dollar amount; the client is
more willing to let go of the reins. That is the beginning of a relationship with potential for growth.
The low-sophistication-low-control quadrant
shown in the lower left panel of the figure is where
so many investment firms assume their clients fall.
A large trust may control the bulk of the assets, and
it often represents a widow or a family group without an interested spokesperson. Here the key objective may be income level, and the client may not
express interest in meeting with the advisor too
often. The temptation is to leave well enough alone,
but if an in-law or a member of the next generation
is eager to learn more, you ignore that person at your
peril. If these people learn without you, they have
Figure 1. Quadrants of Control and Sophistication
Sophistication
High
Control
High
Low
Low
ship in 1992, and the findings are revealing. Of interprobably found one of your competitors to teach
est to marketing people, 80 percent of the institute's
them.
The high-sophistication-Iow-control quadrant
membership recommended their advisors to a
friend, and 63 percent rely on personal referral to find
shown in the upper left panel of the figure contains
those families that most resemble the institutional
an advisor. Clients have friends, and if your clients
market. This is a family or individual who knows
enjoy learning from you and the time they spend
enough about investing to acknowledge that they
with you, they may recommend you to a friend.
should not overcontrol the process. They are looking
Fifty-two percent of respondents plan to add a
for professionals. They relate well to benchmarks
manager this year. Granted, this is the high end of
the market-people with $10 million and more, but
and asset allocation discussions, and they want to
talk about specific characteristics of their portfolios
the results are probably true for other parts of the
and what performance might be expected in differmarket as well. Also, however, 84 percent have fired
ent types of markets.
a manager during the past five years, and nearly a
Finally, the high-sophistication-high-control
third of the institute's members plan to fire a manquadrant (upper right panel) is where you find Monager this year.
day-morning quarterbacks. Clients in this quadrant
_
are likely to have personal computers tracking and
Conclusion
analyzing the purchase price of every security their
Thanks to demographics, the press, investment maradvisors buy. Advisors need to be aware of this, or
kets, an array of investment products, and the prolifthey can be blindsided by such questions as, "Why
eration of investment advisors, the private client is a
do you always buy at the top?" This high need for
very different species than even four years ago. Capcontrol eases dramatically if the first year is filled
italizing on these changes requires considerable conwith education and continued questioning on needs
tinuing education. Your clients will demand it, and
and goals.
your business will depend on it. In the words of Sir
William Osler, a 19th-century Canadian pioneer in
Research Results
medicine, "The best preparation for tomorrow is to
The Institute for Private Investors polled its memberdo today's work superbly well."
Question and Answer Session

Charlotte Beyer
Question: What is a reasonable
number of client accounts a portfolio manager can service adequately?
Beyer: I cannot give you a number because I have seen successful firms at both ends of the spectrum. The number depends on
the support staff. Firms that have
higher client loads must have extraordinary staff and marketing
support that prepares the materials so that when they meet with
clients, they do not have to create
the material from scratch. They
also must have support people
who can take over many of the
telephone calls. I know one firm
struggling because the increasingly sophisticated private client
is demanding so much more.
This firm has 60 or 70 clients per
manager, and it is losing ground
because it does not have the necessary support.
Question: Will the consultant
market become as saturated as
the manager market is now?
Beyer: I believe the consultant
market is in its infancy-accountants, attorneys, and tax advisors
or planners are all interested.
Also, some pension consultants
are changing their stripes and becoming private investor consultants. Nevertheless, many people
still have not figured out how to
analyze the private client situation. This is what I am told by
private investors who are dissatisfied or frustrated with trying to
find someone to help them
through this maze.
Question: Are you aware of the
Sanford Bernstein 1992 study on
the money management indus-
try? How do you reconcile your

position with its finding that the
private money manager client
puts performance near the bottom of the list of manager qualifications this year? Also, what is
your assessment of the study that
says confidentiality, reputation,
service, and so forth come before
performance?
Beyer: I believe that very often
buying behavior can be different
from what private clients say.
Therefore, when doing a study
and asking people why they
hired a particular firm, they may
say what they think is rational. I
have never met a prospective-client who did not ask about performance. How much you tell them,
in what level of detail, and how
appropriate it is to their situations is another story. As for confidentiality, all private investors
assume that is part of the arrangement. Perhaps that study's findings reflect the sample used,
which included smaller, perhaps
less-sophisticated investors, who
were paid to respond.
Question: What are the key reasons managers are fired?
Beyer: My experience in the
field-and research is confirming
it-is that, although you may be
hired for performance, when you
are fired, it is because of service.
People have said repeatedly, "We
fired a manager because we were
tearing our hair out one quarter
too many trying to get the information we wanted and being ignored. So we fired him; we felt
we could always find another advisor who could give us middleof-the-road returns and not have
to put up with the poor communi-
cation./I Typically, advisors are

fired for poor service, which supports the thesis of four years ago
that a relationship is what people
seek once they are clients. Ignoring performance is a mistake,
however. Some managers brag to
me that they never show their private investors their performance.
I think they are asking for trouble.
Question: You stated that advisors and counselors may not be
the same. Do you believe it is unimportant for a private client to
know the person making the
money management decisions
(i.e., the actual portfolio manager)
if a good intermediary can provide the "warm, fuzzy feeling?/I
Beyer: Remember those quadrants illustrating different private
client characteristics. Some clients will not accept not meeting
the person who buys or sells the
securities in their portfolios, but
many people can recognize the division between the manufacturing, the distribution, and the servicing aspect of a product. Some
firms have successfully combined
these functions into one person or
several people. Not every client,
however, insists on knowing the
portfolio manager and meeting
with him all the time. It depends
on how sophisticated they are
and how professional the service
contact is.
Question: If 63 percent of clients use referrals to find an advisor, what does this say about the
role of professional marketing?
Beyer: It says that they ask a
friend and next they contact the
firm. Then, marketing can make
9
a difference. One member of the

institute wanted to place $5 million with an international manager. The member talked to
friends and called 37 firms but
also used a directory. It was
amazing how poorly this person
was handled by the majority of
those firms. Many advisors did
not know what to do with that
"cold" call. So the marketing professional is important internally
when a portfolio manager's client
says, "I want to send Jane Doe in.
She is a friend of mine, she has
some money, and she wants to
talk to you about managing it."
The analysis before Jane Doe arrives-the work on what you will
show her, what you will not show
her, and how the process will be
managed-is critical. Most portfolio managers do not have time
to do this type of analysis. Thus,
they do a standard "Hello. Let
me tell you about the firm" for an
hour or so, and they often lose
the opportunity to gain a new client. In some cases they do not
even follow up. They have the
meeting, Jane Doe comes in,
hears about the firm, and maybe
gets a letter, but then there is no
meaningful follow up. Jane Doe
may have decided not to do anything for six months, but often
the marketing professional is the
only one in the firm who will
keep her informed, maybe have
lunch with her or see her three or
four months down the road, and
talk about how well she is coming along with her search for an
investment advisor. The marketing professional is the person
who brings analysis of every situation to the fore.
Question: Do you think wrap

fees are too expensive?
10
Beyer: Yes, but participating

brokers will tell you the fees are
coming down. Market forces are
bringing them down. Although
many of the big firms do not publicly say they will negotiate reduced fees, that is what they are
doing. The broker makes a little
less money on it, but consider the
mutual funds' load fees. They
used to get 8 to 10 percent, but
those percentages have been negotiated and brought down by
the market.
Question:
ant?
Are fee levels import-
Beyer: No. This does not seem

to be a very fee-sensitive business
yet. When I worked in investment firms, however, my colleagues discussed fees in such a
way that it turned off the prospective client, or they would argue
with clients about increasing fees.
What is important is the way fee
levels are discussed and described. If the process of explaining your firm has been done too
routinely and predictably, when
you get to fees, people will say,
"That is sort of high. Another
firm we spoke with charges less
than that." Now, at last, price is a
topic they feel qualified to discuss
with you. If from the beginning
your presentations are lively giveand-take about what they want
their money to do, fees will be an
afterthought, because you will
have them signed up before you
even mention fees.
Question: Please discuss your
views on the ability of large organizations, such as trust departments, versus smaller investment
counseling firms to serve private
clients.
Beyer: I believe both are

equally capable. The question is
how well an organization manages the "process." To the extent
that a firm has capable leaders
and professionals who are analyzing the process of selling and servicing, the firm will be successful
with private clients.
Question: Given the changes in
the character of the private client
market, do you see more of a willingness or demand for international investing? Also, is there a
trend toward more than one advisor, such as in the pension world,
which uses specialty advisors?
Beyer: Only 8 percent of the
institute's members' assets were
diversified overseas as of mid1992, but virtually three-quarters
of our members said they are
looking at international investments. So of the more than half
of our members planning to hire
managers, practically all are looking at international or global investment advisors.
In response to the trend toward multimanagers, on average
institute members use five managers, but that does not mean a
large bank or a large firm cannot
implement a multistrategy approach. Tad Jeffrey wrote an article about having too manl portfolio managers in the stew. This
was a compelling argument for
having one firm implement a
multistrategy approach rather
than hiring several different
firms. You can argue this both
ways. The trend may stem from
a dearth of ideas or new suggestions coming from the one firm
clients currently are using.
lRobert H. Jeffrey, "Do Clients Need
So Many Portfolio Managers?" Journal of
Portfolio Management (Fall 1991l:13-19.
Investment Planning for Entrepreneurs

Peter Davis
Director of Family Business Executive Education Programs
Wharton School
University of Pennsylvania
As a group, entrepreneurs provide a unique set of challenges to investment advisors.

Because they harbor psychological resistance to dealing with such threatening issues as
estate planning, advisors must demonstrate great communications skills exercised in a
context of trust.
Private clients, as individuals and as families, present some unique challenges to investment advisors.
The financial issues are frequently complex-a web
of intermingled concerns about business strategy,
estate and tax planning, organization and succession
planning, and perhaps most significantly, personal
psychology.
A good scare is worth a pound of advice. We can
talk until we are blue in the face about such issues as
estate planning, but we will not make much progress
until these clients realize some tangible consequence
for not making decisions. Entrepreneurs and
wealthy individuals usually strongly resist dealing
with change in their personal lives. Yet, good financial planning requires anticipating and planning for
change. This deep psychological resistance to dealing with such threatening issues as estate planning
or gifts to the children can be overcome only by great
communications skills exercised in the context of
trust. Entrepreneurs as a group provide a unique set
of challenges to an investment advisor.
The Entrepreneurial Psyche

For most entrepreneurs, the concerns of investment
advisors fit into their priorities in a secondary way.
As I talk to founders and entrepreneurs about transitions, they want to talk about their children, their
businesses, and their strategies, but they do not want
to talk about managing their money. They make a
distinction between wealth creation, which is what
they do, and wealth preservation, which is what the
investment advisor does. In good years, the successful entrepreneurs have seen their corporate equity
grow more than 50 percent a year. Thus, they do not
get too excited when the advisor is talking 7 percent

as opposed to 6 percent. They have also made bad
investment mistakes in the past because they have
never had the time to take investing seriously and
friends have given them a tip that performed disastrously. At base, they do not trust investments they
cannot control.
For most entrepreneurs, wealth preservation is a
reactive process. If they make a lot of money, they
put some away. If they get scared over their own
mortality, they put some more away. They draw
money down in large amounts to fund their pet
projects. Most good entrepreneurs do not look after
their money because deep down they feel they could
always make more. Yet, as we all know, sometimes
looking after your money is important. Throughout
their lifetimes, entrepreneurs build businesses. The
businesses develop net worth, which remains highly
illiquid, and the entrepreneurs develop personal assets, mostly real estate. They also develop personal
liquidity, although not much. They develop significant debts in some phases of the life cycle, including
personal debt and obligations to support their businesses, and corporate debts to finance growth. In
other words, they have many financial pockets, corporate and personal, and how these fit together is
important. Looking after their money is one part of
the puzzle, but entrepreneurs rarely stop to analyze
the total financial picture and look at the management of personal liquid assets in the context of an
overall financial plan.
A recent experience illustrates the importance of
evaluating an entrepreneur's total financial position.
A founder died very suddenly in his early sixties.
Because he had been a healthy man, he had done very
11
little in the way of estate planning. The children

bought the operating business from the founder before his death. They paid little for it because they
assumed the company's debt would reduce the net
worth to precious little. More than $200 million
worth of real estate was placed in the trust, together
with $5 million cash. The value of the real estate was
dependent on the performance of the operating company. The children operating the company were
under the gun from the banks, which wanted to see
better performance and more collateral. The trust
only had $5 million, however, and the trustees had
to worry about the widow and other financial contingencies. The trust had to draw the line on lending
to the operating company, which had no other
sources of capital.
The situation was interesting because it involved
a growing adversarial relationship among trustees,
the family members running the company, and the
banks. Clearly, the estate was not sufficiently liquid.
The founder could not afford to die in a down market. Perhaps the problem could have been solved by
life insurance. Perhaps it could have been solved by
a carefully built pool of liquid assets sufficient to
keep the overall portfolio (business assets, business
debt, personal assets, personal debt, tax liabilities,
and so forth) in better liquidity balance.
Entrepreneurs badly need comprehensive financial planning that subsumes corporate and personal
resources and needs, as well as future liabilities.
They probably find this service hard to get because
the service providers offer a fragmented view of
what they need. Insurance brokers offer an insurance view, accountants offer an "income statement"
view, and investment advisors just want to carve out
a piece of it (the liquid piece) and hold it in a fund.
The new opportunity is in a more comprehensive
approach that looks at investment opportunities in a
broader context and establishes investment goals accordingly. How can we get an entrepreneur to listen
and not feel that these approaches are too expensive,
boring, or constraining? This is the challenge.
Five Phases of Business Development

Investment advisors considering the entrepreneurial
market must lookat investment advice in the broader
context of a client's total financial needs, much of
which is built around the business. They also must
learn persistence in the face of likely stubborn resistance. A third piece of advice is to recognize that the
financial needs of an entrepreneur are very dependent on the business life cycle. Churchill and Lewis
identified five phases of business growth and development, each having different implications for fund
12
management. 1
Phase 1: Existence. This is the founding stage
of the business, in which the founder is the business,
systems and formal planning are nonexistent, loyal
customers are few and far between, and financial
crises are frequent. Collateral obligations intermesh
personal and corporate finance, and capital is desperately short. The founder needs income, credit,
and forgiving creditors.
Phase 2: Survival. The owner is still synonymous with the business, but the business looks more
respectable-as if it will be around for a while. To
ensure survival, the owner takes on major projects
such as building control, hiring an experienced financial officer, and investing in new plant and equipment. In the survival phase, cash management is
key. Whatever cash the business has generated is
used for expansion.
Phase 3: Success disengagement. Success disengagement occurs after 10 or 15 years in the business. By now, the owner may be in his mid-40s and
is a presence in the industry association. The business is established in a niche, with survival likely.
The goal is to keep the company stable and profitable. For the entrepreneur, keeping control is important, but delegating nonessential tasks is the trick.
The founder can now go away for three days, but he
is on the phone every day talking to employees and
getting reports on what is going on-letting everyone know he is always there. He relies on experienced, long-term employees and avoids business
risks. He is cementing customer loyalty, expanding
outside interests, and consolidating wealth.
The business is on a plateau. No exciting new
initiatives are being taken. The owner has reached a
level of security in the business and begins to enjoy
three months in Florida every winter. Typically, the
corporation is converted to Subchapter S status, and
cash is taken out of the business. This is the first
period in which the entrepreneur can be self-rewarded for business success. Priority expenditures
are for life-style projects-boats, houses, and airplanes. Some cash may build up, but the entrepreneur still needs liquidity because large uncertainties
still exist and because of the next phase.
Phase 4: Success growth. The entrepreneur
must consolidate resources and redirect them-usually toward growth. This is because 50 years ago, a
family business could stay on a plateau of success
disengagement indefinitely, but today the rate of
technological and competitive change force frequent
periodic reevaluations of corporate priorities. Every
dollar of corporate equity now becomes invaluable
lNeil C. Clmrchill and Virginia L. Lewis, "Five Stages of
Business Growth," Harmrd Business Review (May /June 1983).
to the company struggle to find the resources necessary to fuel growth. The corporation may be recapitalized, and new partners may be brought in if the
capital needs are extreme. Whatever resources the
entrepreneur has managed to accumulate outside the
business must be conservatively invested to balance
the enormous risk the business is facing.
Phase 5: Take-off. As the owner struggles
with growth, he learns some basic truths. He no
longer knows it all, and he can no longer do it all. He
must learn to delegate and trust, but this is counterintuitive. He has never experienced a real dependency on others, yet he begins to realize that he
cannot get along without significant others supporting him in key managerial and advisory roles. He
begins to open up and seek advice.

For the financial advisor, this phase is an important period of the entrepreneur's life. This is the first
time that comprehensive financial planning becomes
possible. The entrepreneur is seeking balance between time spent in the business and time spent on
personal pursuits, between hands-on direction and
delegation, and between the risk and opportunities
of business and the security of outside investments.
It may be necessary to restructure finances, go public,
bring in new investors, and / or establish an employee stock ownership plan. His personal portfolio
may be built looking forward to the future and taking
on more risk as the business risk progressively diminishes.
13

Peter Davis
Question: How can you convince the business owner that he
can take on additional risk outside his business if his business is
doing well? In other words, how
do you get him out of money market funds?
Davis: Why do you want to do
that? Getting out of money market funds may not be appropriate. Once you get to the risk
issue, you immediately start pushing yourself into client control,
and the typical owner likes a lot
of control. If he is going to have
risks, he wants to control. If you
want to deal with control issues
with him, you will earn every
penny you get. I would suggest
backing off, giving him space, letting him run his business. If you
push too hard, you ruin the relationship. A basic characteristic of
successful entrepreneurs and
14
founders is the need for control.

You are on a leash, and that leash
can be pulled quickly if you lead
him out beyond his risk tolerance.
Question: Do banks have a
unique opportunity to leverage
their client relationships with
business owners in managing
their personal assets? If so, how
should this opportunity be pursued?
Davis: The entry point to many
of these issues, like the estate
planning issue, is through such
entities as banks, accountants,
and lawyers. The relationship
with banks is adversarial today.
The entry through commercial
banking will only take placeand it should take place-because
the commercial bankers have
wonderful opportunities to work
with entrepreneurs to optimize
their financial positions. What

we need is joint optimization of
personal and business finance; it
is a joint-system problem.
The banks must be in an adversarial relationship to some extent because they must look after
their loans. Some breakthrough
is needed in relationships between commercial banks and entrepreneurs before their relationship will grow into something
more than it is today. When Michael Porter, Harvard's guru on
strategic planning, was asked
about competitiveness, he said,
"We must revolutionize the relationship between banks and companies. We must be like the Germans. We must build those kinds
of long-term relationships." He is
right, but we have a long way to
go to build them.
Investment Planning for Wealthy Families

H. Scott Miller
Portfolio Manager
Miller, Anderson & Sherrerd
Families should be encouraged to see their portfolios as an integrated whole rather than
a collection of unrelated assets. This stretches the portfolio manager's traditional role to
include communication as well as analysis.
Private investors usually have a weak sense of their

portfolios. When they have a sense of it at all, it is as
a loose collection of individual marketable securities
unrelated either to changing economic or investment
scenarios or to each other. Assets that may not be
readily marketable because of control considerations, tax implications, or illiquidity are totally ignored. It is striking that these less marketable, nontraditional assets are often larger than the marketable
securities in a family's portfolio. These positions
may be in closely held public companies, private
companies, real estate, or other exotic assets, and
they may dwarf the marketable securities the family
usually defines as its portfolio.
Our mission is to help families recognize that
these large, core positions are part of their portfolios,
to identify characteristics that relate these to other
assets in the portfolio, and to act as the sounding
board for strategies to maximize value. The remainder of the portfolio should be structured to complement the characteristics of these core assets. To maximize clients' welfare, portfolio managers must expand their role to developing strategies that account
for the influence of these often-dominant core assets.
This includes scenario analysis that incorporates estimates of the volatility of and correlations among
these assets, and an evaluation of tactics that affect
corporate strategy and governance. In this presentation, I will discuss defining and managing broader
portfolios for wealthy individuals.
Portfolio Definition
Understanding why individuals regard their portfolios as they do is related to how they happen to arrive
on our doorstep in the first place. Families come to
us for several reasons. First is the transfer of assets
or liquefying transactions. Davis referred to this

when discussing the crisis that develops when a
company is sold or creates liquidity and the family is
suddenly faced with dependence on a pool of cash as
opposed to a very comfortable company structure. 1
Liquefying transactions may occur for many reasons.
They may be special dividends or recapitalizations,
and in the 1980s, they were leveraged buyouts.
Today, they are typically initial public offerings or
inheritances. The family usually considers the event
to be more of a burden than a blessing.
A second reason families come to us is that they
believe some of their assets are underperforming the
market. This belief is typically more anecdotal than
systematic. In today's environment, they may think,
"Cash returns seem low, so invest in bonds," or
"Health care stocks are underperforming, and I don't
understand why." Whatever the reason, the motivation for meeting with their advisors is usually a
vague sense of unease.
If a specific investment need is stated at all, it is
usually expressed arbitrarily. We have learned not
to take the specific statement of need at face value.
Rather, we ask the families to describe their existing
portfolio to obtain their concept of it. The usual
answer is that they own some equities, bonds, and
cash. Most of it is managed by money managers or
banks. Families rarely describe these managers in
relevant investment terms. For equities, families
may list particular portfolio managers or mutual
fund holdings, but they describe them in terms of the
name of the manager or some vague feeling about
him-"He trades a lot," "He has been in the business
a long time," or "He buys big-capitalization stocks."
The equity portfolio is never described in terms of its
role in the overall investment strategy.
l See Mr. Davis's presentation, pp. 11-13.
15
Families usually describe any asset with a coupon as a bond holding. They ignore duration, structural features such as options, and other concepts
describing interest rate sensitivity. Total return and
other measures for tracking performance under different scenarios are lost in this process, and bonds are
rarely considered for use as a portfolio tool.
Cash is usually described in terms of access
rather than performance. The result is a drastic underestimation of the amount of cash in the portfolio
or, more properly, a dramatic overestimation of the
amount of bonds. In a portfolio sense, many
investors' bond portfolios are much closer to cash
than bonds because of short maturities and call risk.
In short, families begin the discussion of their
portfolios with a weak sense of the marketable securities they own as contributors to the portfolio, and
this attitude carries over to their less liquid core
assets. They do not have a sense of the correlation of
asset returns nor their variances. Managing holdings in a portfolio sense is ignored.
Core Assets
The next step in the planning process is to develop a
more inclusive definition of the portfolio. Families
need to be pressed to answer the question, "What
else do you own?" In our experience, many families
will disclose only a fraction of their assets. For example, a family may want to put $5 million in bonds and
stocks. Upon further discussion, we might find that
the $5 million is part of a $25 million portfolio of
bonds and stocks. After much prodding, we may
also find the family has a $200 million position in a
closely held company or a $150 million equity position in high-quality real estate assets.
Typically, the family fails to mention the entire
$25 million portfolio or the $200 million position, not
because they are withholding information but because they do not understand why it is important.
The family does not consider these assets to be a part
of the portfolio because they do not consider them
securities. Often, the characteristics of these assets
cannot be easily changed or adjusted in the short run.
Our goal is to help the family recognize the existence
of such assets, see them as securities, and understand
the influence they may have on structuring that part
of a portfolio that can be changed. The odds are that
they will develop some sense of how these core assets
relate to other asset classes under different economic
scenarios and, consequently, how they may provide
a departure point for developing an investment strategy for the remainder of the portfolio. This analysis
may only be possible conceptually rather than quantitatively, but it still provides a departure point.
16
The difficultly in structuring this analysis depends on the nature of the core position. A core
position in the stock of an actively traded public
company presents the easiest challenge, although the
particular form this challenge takes depends on, for
example, the family's attitude toward its 35 percent
ownership. Is it seen as a source of income or a
growth vehicle? Is there a close emotional identification, or is it simply an outsized investment? Whatever the answers to these questions, its status as a
public company allows us to obtain data on these
core assets that one can begin to objectively analyze
on the client's behalf.
The values of private companies are much more
difficult to assess. We can create a straw man resembling the private company, but problems of liquidity
and realizing value make estimating performance
under different scenarios difficult. Nontraditional
core assets-real estate, agriculture, or art, for example-present huge problems in valuation and risk
analysis.
Structuring the Portfolio

With all of these difficulties, the discussion with
families comes down to defining what is meant by a
security. All securities have values and prices, although these may not be readily identifiable. Underlying these values are cash flows. Helping clients
think of their core assets in terms of these qualities as
a security or group of securities is an important first
step in understanding that securities are dynamic.
In the case of real estate, the family must understand that shopping centers or other assets they own
generate cash flows, that cash flows have a value in
the marketplace, and that these values are influenced
by structural aspects of leases such as terms, prepayment clauses, and escalation clauses. Clients must
understand that even art collections have cash inflows and outflows for their maintenance, insurance,
and security.
Alternative uses of assets are often left out of the
determination of value. This is true in obvious cases
such as a dairy farm, but it is also true in a corporation, particularly in a privately held corporation.
If we help the family understand its core position, if not as securities, at least as assets with
securitylike characteristics, then we have helped it
redefine its portfolio-structuring process. The marketable securities, which the family may have considered the outer boundary of its portfolio, become a
balancing factor at the end. Concepts such as bond
duration and stock portfolio volatility cease being
purely academic and become more interesting and
relevant. The individual who begins to understand
that his company, which services the steel industry,

may do poorly in a deflationary period understands
the value of having a deflation hedge as a balance
against the unalterable characteristics of this core
asset.
Conclusion
This approach has many perils for an investment
manager, who must wrestle with its many implications. At his peril, the portfolio manager may
be drawn into issues of corporate strategy. This can
include wealth- and liquidity-maximizing techniques such as recapitalizations, leveraged buyouts,
and new issues, which are traditionally the province
of the investment bankers. Ensuring that family
members are talking to each other is an essential first
step in including these nondivisible core assets in the

portfolio-planning process. Against our will, and as
an unavoidable first step, we might be involved-either directly or by recommending someone else-in
helping to develop a structure enabling the family to
discuss these matters and reach consensus.
In summary, families should be encouraged to
see their portfolios as an integrated whole rather than
a collection of unrelated assets. This implies
challenges of analysis and communication that
stretch the portfolio manager's traditional role.
Meeting these challenges is difficult but essential to
answer questions families implicitly or explicitly ask.
The irony is that the purely professional portfolio
manager of the 1990s starts to see himself as a 19thcentury personal banker.
17
Asset Allocation for Private Clients

Jean L.P. Brunei, CFA
Managing Director and Chief Investment Officer
J.P. Morgan Private Banking Group
An "average" private client does not exist. Each one presents a unique set of investment
needs. The four main factors to consider in building a portfolio for a specific individual
are tax and legal considerations, portfolio context, income requirements, and multiple
requirements.
Strategic asset allocation for private clients usually

means trying to fit the allocation to a client's longterm goals. Thinking about asset allocation for the
private investor may well be the most exciting part
of my job. The challenge involves using some of the
most sophisticated tools available in portfolio theory
and adapting them to human clients. The French
have a saying: "You can only express clearly what
you understand fully." This is exactly what our clients want of us. They expect us to think through
everything, but they do not want details unless they
ask for them.
The Myth of the Private Client

At J.P. Morgan, we believe the private client, as a
group, does not exist. When I moved from the institutional investment side to our private banking
group, I found out that this "group" is a large variety
of individuals with a large variety of needs. Our
challenge is to identify these needs and classify them
so we have client segments with which we can operate.
The typical efficient-frontier-type analysis does
not work in most private client situations. This analysis has been developed during the past 15 or 20
years principally in an environment of tax-exempt
and unconstrained investors. The typical private
client has taxes and many other needs and constraints, which make efficient frontier analysis impractical. The challenge is to develop new thinking
about a world of constrained investments.
To explain why private clients cannot be considered a homogeneous group, ask three questions:
Who are these people?
What do they need?
18
What are they looking for?
Who Are These Clients?

When faced with problems, people like to look
first at simple dichotomies. We do that when looking
at our collective marketing in investment management. We like to think in contrasts-institutional
versus private, small versus large, sophisticated versus unsophisticated. For the private client, that does
not work.
Three examples illustrate this point. First, what
can we say about the pension fund of a privately held
company? Will it be managed like the fund of a large
company or like the owner's private assets? There
are no rules. Knowing this is the pension fund of a
private company does not tell us anything.
Another distinction is between inherited wealth
and self-made wealth. Both classes are taxable, but
will they have the same risk profile, time horizon, or
attitudes toward intermediaries? If the self-made
wealth resulted from a leveraged buyout, does that
make the individual more or less inclined to use
financial intermediaries?
Finally, and more generically, families usually
have more than one member. What makes us think
all these diverse people will have the same objectives,
interests, or needs in investment service?
Clearly, thinking unidimensionally does not
work. In a multidimensional environment, clients
must be analyzed along several axes. Figure 1 shows
the various axes we use:
Is the client taxable or not?
How does the client choose investment managers?
Do any special cultural factors need to be considered? For example, Muslims cannot earn interest, the
Figure 1. Thinking Multidimensionally
held.
Tax Status
Level of
Sophistication
Buying
Behavior
Cultural
Habits
Do any legal or regulatory requirements affect

the investment decision process? U.S. trust laws impose
Economic
Rationality
requirements to deal with the conflicting interests of

income beneficiaries and remaindermen. Is there a
list of eligible instruments? Who in business school
has not heard about investment-grade securities? If
you go to Singapore, in certain instances, you may
not own stocks that do not have trustee status; trustee
status there means, among other things, that the
company must have paid a minimum of five consecutive years of dividends. Limits may be imposed on
the use of derivative instruments, short sales, offshore instruments, or commingled vehicles (e.g., mutual funds, unit trusts, and common trust funds).
Servicing
Requirements
Size
Legal Structure
Source: J.P. Morgan.
typical wealthy Italian will not own much stock, and

U.s. citizens consider having 10 percent of their assets offshore a huge international commitment.
What kind of servicing requirements does the

client have? How often does he want to talk to youonce a month, once a quarter? When does he want
to talk to you-when you make a transaction or at
regular intervals?
How sophisticated is the client? Is he aware of
and interested in investment and capital markets
theory? Some of our private clients are sophisticated
by these standards, and some institutions are not.
Does the client make decisions solely on economic

grounds?
How big or small is the client?
Do any special legal issues affect this client?
What structure will hold the assets? What are the
estate tax considerations? For example, non-U.s. citizens, even those not living in the United States, must
pay U.s. estate taxes on any U.s. stocks they directly
own. When managing the money of someone outside the United States, be sure to have a holding
company in the middle so the client is not exposed to
estate taxes, which he does not have to pay and may
not even be aware of.
Mapping out this client base involves thinking
multidimensionally. The strategic challenge we face
is nothing more than building a small enough number of large enough clusters of private clients so we
can make this a business.
What Do These Clients Need?

Portfolio managers think of portfolios from their
own standpoint; we must change our focus and think
of the portfolio from the client's standpoint. A key
question is how (if at all) are the client's investment
needs constrained? To answer that, pose the following three questions:
Is the client taxable? When moving to the
taxable world, you must think about differences between capital gains and income. Total return may no
longer be applicable. If you operate in a jurisdiction
under u.K. influence, you must think of the difference between trading and investment income. Taxes
make a difference in the way instruments should be
Might any individual requirements compel an

adjustment in the decision process? These restrictions
can involve large core holdings of public or private
companies, other assets, personal likes and dislikes,
and a variety of other considerations that might be
crucial to the investment decision-making exercise.
When thinking of solutions that might satisfy
our clients, we like to apply four key tests:
The portfolio must make sense from a
tax and legal standpoint.
It must make sense when viewed together with the client's other assets.
It must meet the client's income requirements.
It must meet the conflicting needs of
multiple beneficiaries.
What Are These Clients Looking For?

Looking at return expectations is not enough;
risk and time horizon are important, too. The problem is that people tend to think and talk very differently about these things. What one says may not be
what another will say. For example, at one extreme,
certain clients think in "product" terms. Product
buyers have thought through their investment
needs, reviewed all the alternatives, and arrived at
their own conclusions. Although arguably an oversimplification, they do not come to you with a problem but with a solution. They expect you to deliver
a certain product, usually defined in specific, assetrelated benchmarks and eligible instruments.
At the other extreme is the "service" buyer. Service buyers can articulate their investment objectives, but they are unaware of or uninterested in the
investment alternatives available. They want you to
make recommendations on what is best for them.
They come to you with a problem, looking for a
trusted advisor who will give them a solution.
By now, you can see why we believe the private
client is a myth. Some theater plays in France are
19
based on two people who look at the same thing but

see something completely different. The same applies to investment clients: Two people can say the
same thing but mean something completely different. When taxation, income requirements, and other
assets are layered on, client needs are so complex that
thinking of them as the same is misleading.
Strategic Asset Allocation

A portfolio for a specific individual is based on four
characteristics-taxability, portfolio context, income
requirements, and multiple requirements.
Tax and Legal Considerations

Portfolio building for taxable clients has two
crucial dimensions. First, all return expectations
must be in aftertax terms. Returns are composed of
three elements-distributed income, realized capital
gains, and unrealized capital gains. Only the first
two are taxable in the United States. There are two
models for building portfolios based on aftertax considerations. One is a tax optimizer that has the purpose of maximizing end-of-period wealth, as opposed to periodic return. The other model is a tax
swap analyzer that judges any transaction on the
basis of whether the alpha that will be generated on
a new asset class or security to be purchased is
greater than the combination of the alpha generated
on the asset to be sold and the capital gain tax liability
on that asset, if sold.
The other dimension is less obvious but not less
important. Clients may be holding low-cost-basis
securities-securities with book values for tax purFigure 2. Completion Portfolios
poses that are much lower than their current market

values. These can be dealt with in three ways. Figure 2, showing a completion portfolio, illustrates the
first. The idea is to keep the low-cost-basis security
and structure a subportfolio using both physical and
derivative instruments, as appropriate and as allowed by regulations. The combination of the two
subportfolios behaves like a reference index (with
which the client is comfortable), but it does not require the sale of the low-cost-basis stock.
The second technique, tax-aware indexing, is
illustrated in Figure 3. This idea is to build an index
fund using a sampling technique in which more than
one combination of securities will meet the objectives. In any market, stocks go up and down. The
trick is to use any loss generated within the index
portfolio to offset the gains generated by selling lowcost-basis securities. If one stock goes down, sell it
and find another stock to replace it in the sample.
The loss just booked can be used to offset some of the
gains from selling a low-cost-basis security. When
the share of the low-cost-basis securities in the portfolio has reached a comfortable level, the whole portfolio may again be managed more actively to provide
a little more alpha.
Figure 3.- Tax-Aware Indexing
Low-CostBasis Stock
Stoc s
Index
Fund
Sale triggering capital loss permits sale of low-cast-basis stock.
Tax-free equity swaps, illustrated in Figure 4, are

the third possibility. This technique is valid in certain instances only. The idea is to swap the financial
interest in the low-cost-basis security against a managed or unmanaged portfolio for a limited time. At
the end of the period, capital and income flows are
equalized so you regain control of the low-cost-basis
security without incurring any gains or losses. During the interim, you benefit from the performance
Figure 4. Tax-Free Equity Swaps
Stock dividend
f--------..
Holder of
Low-CostBasis Stock
Selected
Attractive Securities
20
I""-
Interim Flows
-------
S&P 500 Dividend

Stock Value
Final Flows
S&P 500 Portfolio Value

Note: All payments at same time made net.
Financial
Intermediary
characteristic of the managed or unmanaged portfolio rather than the performance characteristic of the
underlying stocks.
Implicit in these three examples is the warning
that whatever you do must be in line with tax and
accounting regulations. For instance, building a derivative-based strategy would not make sense in an
environment in which using derivative securities is
not allowed.
Portfolio Context
Our clients expect us to look at their whole financial picture. We follow two policies. First, we keep
in mind the wealth cycle as it affects liquidity needs.
The wealth cycle has four stages: acquisition, liquidation, management, and distribution. Before the
1980s, the bulk of our industry's assets came from
people in the management and distribution stages.
During the 1980s, when so much new wealth was
created, the new clients who came in tended to be still
in the first stage, although they may have already
liquidated some of their assets.
When structuring a portfolio from a client's liquid assets, we must appreciate that he is still in
business. That business at some point may have a
financing need and may have to draw upon the
portfolio to provide liquidity. Placing this client in a
lO-year closed-end limited partnership would be a
mistake. Conversely, the client may be in a substantialliquidation phase. The client's business might be
a set of real estate investments with some regularity
in payment, or the client may be otherwise producing liquidities that will come into his portfolio. In
this case, the structural asset allocation should not
have a large amount of cash in it.
Our second concern is fiduciary issues. A client
may consider something to be part of his wealth
when it no longer is. For example, we were discussing with a client the management of several facets of
his wealth. The client did not like equities, in part
because more than half his wealth was still in his own
public company but also for more emotional reasons.
At one point, we started talking about a charitable
remainder trust that would be a discrete entity on its
own. We explained to the client that these assets
would have to include a meaningful commitment to
equities because we had to think only of the objectives of the trust. The assets could not be considered
a part of the client's wealth, and his own preferences
had to take a back seat to the trustee's fiduciary
responsibilities. Believe it or not, the client bought it.
Income Requirements
Income requirements are the third input to the
asset allocation decision. Where mandated by law or
because of personal needs, several of our clients require specific income payouts. For a foundation, for
example, the payout might be constrained to the 5
percent minimum income requirement that protects
it against taxability. An income requirement can be
provided for in a legal document. In some instances,
the document may specify how that income must be
generated-through dividends, interest. or selected
currency transactions and not from realized capital
gains. As Figure 5 illustrates, this constrains how the
portfolio is structured, because it must be able to
achieve the long-term expected total return the client
desires and also generate the required amount of
income. We have constructed algorithms that allow
a manager to describe to the client the spectrum of
portfolio structures that will meet these objectives.
Figure 5. Income Requirements-Thinking in
Constrained Return Terms
10% Return Target
10% Return Target
Capital
Capital
-----
Income
Income
Multiple Requirements
The most common example of multiple requirements is shown in Figure 6. This is a trust that has
conflicting requirements. The income beneficiaries
would like to get everything they can and forget the
remaindermen; the remaindermen would like to pay
no income out but to invest in things that will produce more value in 20 or 30 years, when they get the
money.
Figure 6. Multiple Requirements
----.====:::::;----------
Remaindermen
The chief executive officer of a large company

came to us with a fortune that needed structuring
and management. The assets were to be held in three
pockets-a discretionary individual account, an In21
dividual Retirement Account, and an advisory relationship in which the client directed trades. The
client sought advice as to what the best strategic asset
allocation would be, considering specified income
needs and capital projection objectives. The solution
involved determining that different pockets of assets
would receive different tax treatments and running
efficient-frontier-type computations using both taxable and tax-exempt expected returns. The key to
winning the mandate was to look at all three pockets
relative to one another.
Client Communication
Clients require a lot of advice. You may have to use
tools beyond a client's level of interest or sophistication. You must explain whatever you do in an understandable way and address the problem from the
client's perspective. If the client is interested in the
tracking error of his equity portfolio, then talk about
tracking error.
We owe our clients our best possible advice, but
we do not help them if our advice makes them un-
22
comfortable and they reject it out of hand. A fine line

exists between the world of what is right and wrong
and the world of what is acceptable and unacceptable. The key is communication skills. To a large
extent, investment managers are like ducks-calm
and collected on the surface but paddling like mad
underneath. The challenge is to make technology
accessible, nonthreatening, and understandable, but
that does not mean clients are so unsophisticated you
do not use it.
Conclusion
I have tried to articulate two thoughts. First, the
average private client does not exist. We need to be
very specific, understand who these people are, and
be prepared accordingly to do a lot of tailoring. Second, there is no easy answer to the question of how
to manage the wealth of private clients. Weare in an
evolutionary phase. Ten years from now, the industry will have undergone the same amount of change
as it has since the ERISA business 10 years ago.

H. Scott Miller
Jean L.P. Brunei, CFA
Question: What are J.P.
Morgan's five client segments?
BruneI: Product, performance,
illiquid entrepreneur, hybrid, and
not-for-profit. The hybrid segment comprises investors with
the characteristics of the service
buyer and the product buyer. In
that group are partners of major
financial services and industries,
legal firms, CEOs, and many notfor-profit organizations.
Question: Do you have minimum equity exposures for splitinterest trusts such as those with
income beneficiaries and remaindermen?
BruneI: Currently, the minimum equity exposure is about 50
percent. A year ago, we began a
major project that involved determining whether a change is required in the investment theory
to approach the issue of split-interest trusts. Our suspicion is
that the traditional 50 percent in
place is too high, but it is too
early to prove it.
Question: Please explain taxfree equity swaps.
Brunei: Let's assume you want
to swap a position in General Motors for wider exposure to the
S&P 500. You would swap your
interest in General Motors' shares
for an interest in an index fundone managed by Morgan Stanley,
for example. Now, suppose General Motors' stock price increases
by 10 percent, the equity market
increases by 5 percent, and they
both pay the same dividend. At
the end of one year, Morgan Stanley returns your General Motors'
stock minus 5 percent, which is

the amount the index fund underperformed the price of General Motors. Alternatively, if you
own XYZ, which does not move
in price, at the end of the period,
you get back your stock and you
receive 5 percent from Morgan
Stanley to offset your stock's underperformance. This is a way of
trading your exposure to the
price characteristics of General
Motors-in this instance, for the
price characteristics of the market.
This makes sense for some
people. For example, you might
be uncomfortable with so much
of your money in General Motors, but you do not want to sell it
because your cost basis is only $1
a share. If the stock is trading at
$30, taking a capital gain of $29
would be an expensive hit. So,
you try to diversify part of it and
still keep your General Motors.
This strategy is an alternative to
using options and derivatives to
reduce exposure to a stock without selling it, but you should
check regulatory requirements to
ensure that it makes sense in any
specific instance you may be considering.
Question: How do you express
return in aftertax terms?
BruneI: Basically, you express
return in the same way you
would pretax, except that you adjust for taxes. Two of the three
components of return are taxable.
You apply expected taxes to income and realized capital gains.
The trick is to estimate the share
of capital gains that will be realized. To do this, you must estimate what your expected portfolio turnover is. If you expect port-
folio turnover of 100 percent,

then effectively 100 percent of
your capital gains, and thus total
return, is taxable. If you assume
your portfolio will have a turnover of 50 percent, then only half
of your capital gains will be realized in that year. In an aftertax
environment, the unrealized capital gains portion of return will remain untaxed.
Question: What is the average
time duration from initial discussion to commitment by the client?
Miller: This business takes a
long time. You cannot expect to
make your presentation one day
and get the answer the next afternoon. Weare trying to build
trust, but that trust is not based
on potential clients liking us. It is
based on their feeling that we understand their problems and are
useful to them. That takes a lot of
dialogue and several meetings.
BruneI: One of my statistics professors at Northwestern said, "If
you put your head in the refrigerator and your feet in the oven, on
average, you are comfortable."
On average, it takes about two
years to get a client, but the range
can be wide. A few weeks ago, I
flew to Geneva overnight on
Thursday, made the presentation
on Friday, and on Monday we
were appointed. In other instances, we have been in discussions with clients for several
years.
Question: Are private client
fees based on services rendered
or are they bundled?
Miller:
The nature of this busi23
ness lends itself toward a single

fee.
Brunei: A new trend may be
emerging: asking managers to
quote a fee inclusive of transaction costs. Typically, portfolio
managers charge fees on the assets, and brokerage costs through
third parties are part of the cost of
the security. Some people ask
their managers to estimate what
the brokerage will be and effec-
24
tively take that out of their own

pockets. I object to that strongly,
but be aware it is happening.
Question: Is a U.S. citizen subject to estate taxes in any foreign
country through ownership of foreign securities? If not, why? It
seems that other countries would
have retaliated.
Brunei: This is a very complex
question that has no simple an-
swer. Broadly speaking, a number of major foreign countries

would not tax foreigners, because
they follow or adopt policies
aimed at attracting foreign investment. Others, such as Japan,
might take a stance similar to that
of the United States. As a rule,
you should look at the laws of the
country in which the investment
is made and review treaty arrangements with the United
States, if applicable.
Servicing the Private Client-Part I

Brian A. Murdock
Vice President and Senior Portfolio Manager
Merrill Lynch Asset Management
Private clients differ from institutional clients, and understanding the distinctions is
important. Analysts can use this information to develop an approach to dealing with
private clients that addresses their unique needs.
Servicing the private client requires responding to

the client's individual concerns, which can be somewhat distinctive, rather than fulfilling the standard
requirements of an institutional assignment. All too
often, portfolio managers are too busy doing their
own thing, and they forget their client's objectives.
This presentation provides some examples of how I
focus on servicing private clients, emphasizing the
differences between institutional and private clients.
Private Clients
Although private clients are quite distinctive among
themselves, they do have some common characteristics. One is how wealthy they are. The industry uses
different terms to define wealth, but the basic distinction is that someone who is super-rich has to work
hard to spend all his money, and someone who is not
super-rich does not. More important, super-rich investors differ from not-so-rich investors in experience, sophistication, and temperament. For example, someone who is very rich tends to diversify
among institutions and portfolio managers. These
investors tend to be more focused on each individual
portfolio manager than investors who entrust their
entire fortune to one manager. They tend to be more
patient with results, more philosophical about disappointments, and more specialized in their use of
financial intermediaries.
Another distinction is between old and new
money. Old-money people grew up with money and
are often more comfortable with handling it and
working through intermediaries such as accountants, lawyers, and trust officers. These relationships
may be generational. The advisor may have been the
parent's or grandparent's advisor, and a lot of loyalty
may be involved. Investment managers often deal
less directly with old-money clients because they are

dealing through intermediaries.
Other clients-entertainers, for example-interact through agents. In these cases, the clients can be
thought of as institutional clients, because no private
client contact takes place. This is new money, but
entertainers and sports figures are in some ways the
exception to the rule about retail clients. Because of
their professional agents, they tend to make the relationship resemble an institutional one.
People with first-generation wealth-those who
made their own pile of gold-are usually more control oriented. They are less sanguine about delegating authority over their money. They trust their own
judgments because of their personal success.
Individual versus Institutional Clients

Private clients differ from institutional clients in at
least five ways, and understanding those distinctions
is important.
Private clients' money has "an ego" because it is

theirs. For private clients, investing is emotional.
Institutions may be demanding, but their demands
are within the narrow context of the way the game is
played. They understand the protocols involved,
and they accept standardization of the process. They
want more detailed reports. Most of their demands
are within the pro forma of due diligence involved in
quarterly meetings. The money is not theirs; they are
fiduciaries. An interesting exception to this lack of
personal interest occurs in dealing with a 401-K pension plan of which the board members have big
slices. They may be a little less clinical and philosophical and a little more emotional when their own
money is at stake.
With private clients, ego and money go together.
25
People feel that if their money does not buy them

respect, what good is it? In fact, the person with only
$2 million is more concerned that you notice that he
is wealthy than a person with $20 million. Being
mindful and deferential does not cost you anything.
That is the operating rule in dealing with private
clients.
The relationship is paramount. By having a
good relationship with their private clients, managers address the ego issue and provide a level of
comfort. Such clients are more willing to communicate and work with their managers. A good relationship can be an emotional value-added that gives
managers the competitive edge of loyalty. If these
managers should get into a cycle of poor performance, a good relationship with private clients will
get them through. The situation is more pragmatic
with institutional clients than with private clients, an
important distinction. Managers are fortunate if
they have a warm relationship with their institutional clients, because the players change frequently.
When dealing with clients, personality matters;
with institutions, I am more inscrutable. My approach to institutions is like writing opinions for
public consumption in the newspaper: You are on
both sides of every issue, and whatever happens the
next morning, you can say you were right. When
dealing with private clients, you can show a little
more of your personality and be open with them
because you have more points of contact. Managers
should not have a detached inscrutability with private clients, nor should they rely on the services their
firms provide. Relying on the firm's reputation is
easy-until it fails to work.
Private clients are communications sensitive.
With institutions, managers go before the board during the quarterly meetings and do what is expectedreview the existing portfolio, appropriate periods of
performance, current view of the markets and expected trends, and what the client should expect in
the way of possible changes to the portfolio. This is
all done in a well-prepared and formal presentation.
This approach is not necessarily inappropriate for
private clients, and in fact, many of the same points
are covered in private client consultations. The review is less structured, however, often less detailed,
and the emphasis can be quite different.
With private clients, the manager's function is to
reassure and to provide comfort. Managers must
have an established relationship and constantly
work on that relationship by being communication
sensitive. Markets go down, and relative performance can be inconsistent. When that happens, clients must have a high level of confidence in their
managers. Otherwise, the worst happens-the client
26
quits-usually at the bottom of the market. I call this

the mattress syndrome. At the lows, private clients
can put their money in their mattresses, but institutional clients will find another manager. Being proactive is important-ealling people and handholding as needed, as opposed to simply going down
your list of clients.
Private clients are loss averse, not risk averse.
Private clients have shorter time horizons than institutions. They say they are not risk averse because
they shifted their money from certificates of deposit
to your firm to be managed. In reality, however,
their shorter time horizons-or undefined time horizons-put them more at risk. If anything, they are
aggressive in their risk taking and in their returns
expectations. Private clients do not have actuarial
time horizons. Most do not quantify risk the way
professionals do, and they are not philosophical
about losses. What they fear most is losing ground.
They hate losing money more than they hate underperformance. Managers usually get less grief
from a private client about underperformance than
about losing money and not creating wealth.
Private clients are interested in total returns, not
relative returns. Relative performance is how managers are measured by their peers and their firms, and
it is the way they like to keep score on how they are
doing. Private clients, however, are usually total
return oriented rather than relative performance oriented. After all, they cannot eat relative performance. In 1989, average accounts in U.s. equities
were up between 35 and 40 percent. Then 1990 came
along, and the market went down 6 percent. The
average stock, measured by Value Line, was down
closer to 20 percent. If a manager had average performance in both years, he would have a positive
two-year record. Most private clients, however, do
not average the two.
Being a hero in your company does not pay if
your accounts are at risk. Be mindful of that with
private clients. When your returns go down, give
your service mode full acceleration. Because private
clients are not focused on relative performance, they
do not think you are a hero.
Professional Response
Portfolio managers should develop an approach to
dealing with private clients that addresses their
unique needs. Several professional responses are:
Be flexible. Institutions accept more standardization than private clients. Individuals do not
like cookie-cutter service, so managers must be flexible.
Develop a personality. This is a generaliza-
tion and a subtle one at that. Institutional relationships often are politically sensitive, and cautious
managers will minimize their personalities and emphasize the process and its results. Many mediocre
money managers thrive for years with private clients
who simply like their personalities (ask any Swiss
banker). In any event, a warm personality and a
sense of being honest and forthcoming is appealing
to individuals but may create controversy with an
institution.
With private clients, be willing to customize and
answer questions that seem inappropriate. Do not
try to be too efficient; be relationship oriented. Managers can be technically right-knowing they are
right and knowing the client is wrong-but they
cannot just be right; they also must be listened to.
Managers must develop client confidence and earn
credibility over time. Even a relationship of several
years' duration can sometimes drift away, and you
must reestablish your credibility.
Be proactive with communications. Try to be
the initiator in communications, even with institutional clients. I remember well the crash of October
13,1989. The market was down 200 points on Friday,
and I spent Sunday calling my clients in the Eastern
hemisphere saying we would sell if they wanted to.
I did not want to, but I did want to let them know
they could reach out and touch me. I knew what the
market was going to do on Monday but did not want
everyone calling on Tuesday to say they had not
heard from me and they wanted to get out. Managers must have open lines of communication and not
let their clients feel they are hearing from them only
through a quarterly letter.
Educate your clients. Managers should educate their clients and set targets constantly. They
should cultivate appropriate expectations. A measure of success is being with the private client a long
time. If you have a long relationship, you are successful by definition. Long relationships are established by exceeding expectations. To exceed expectations, managers must first establish the expectations. If managers are only reactive to what their
clients say, their investment activity and subsequent
performance will be all over the place. Instead, they
should set some standards for measuring success.
Get their clients to think in relative terms. That will
be helpful in the short run, but in the long run, clients
will still think about the opportunity cost of riot being
somewhere else for better absolute returns.
The noise of the market can be distracting, so I
try to turn it down. I do not have a price machine in
my office, and I am not patient with questions about
what the market did yesterday and what it is doing
this morning. I do not care. I work in every currency
in all the markets around the world. My portfolios

carry a lot of beta, and I cope with that by not focusing on it.
When dealing with private clients, having the
confidence of your clients is critical so you do not get
a lot of telephone calls. When clients call to discuss
headlines and market psychology, they are turning
up the noise volume, and you must turn it back
down. You must have established the relationship,
maintained communications, and cultivated expectations to be able to cope with their abrupt reactions
to the inevitable market surprises. When the clients
are controlling market timing because they are responding to market psychology, you must be in better control. Respond quickly, so they do not dwell
on the matter too long.
Because private clients dwell on absolute rather
than relative results, managing time horizons is important. Clients want to keep them short, particularly when the market is falling, and managers want
to keep them long. Managers keep pushing those
horizons out, and the clients keep pulling them back
in. Time horizons must be managed constantly.
Show conviction, and be precise. One way to
get credibility quickly is to show conviction and be
precise. A colleague is always after me not to be too
declarative in the quarterly letters: "Don't say anything; just talk about what happened." Private clients do not remember so much what you said as that
you said it. So make a statement. Have conviction.
Do not be a hedge manager, or the clients will feel
they are not getting an answer from you. Do not
sound like every other institutional person but rather
like someone willing to tell the client exactly what he
thinks.
Make money. Nothing succeeds like success,
and making money for people works well. With
private clients, consistency is everything. Managers
do not have that relative performance hook to hang
their hat on, so they need to focus more on highs and
lows rather than tops and bottoms in the markets and
on being very careful. A good rule of thumb is this:
Service accounts to retain accounts. With private
clients, service is everything.
Conclusion
Relationships with institutional clients can be more
or less programmed. As portfolio manager, you
have an established role to play, and the other participants are familiar with the entire process. This produces a good deal of tacit understanding. Often, the
view of a consultant to an institutional client is that
27
the portfolio manager must fulfill a specific role.

Further, the consultant is typically unhappy with
portfolio managers who deviate meaningfully from
their established role.
Private clients may be oblivious to the elaborate
process that institutions have come to expect. Even
28
if they are familiar with the institutional process,

they do not care to have it applied to them. Private
clients are not completing a due-diligence process
but rather pursuing a service that satisfies their expectations and egos. Private clients want a service
that revolves around them.
Servicing the Private Client-Part II

David L. Mead, CFA
Vice President and Chief Investment Officer
Harris Trust and Savings Bank
Investment managers for individual clients must pay attention to what these individuals
consider important. Because this can differ for wealthy and ultrawealthy individuals,
they require different approaches. In general, however, servicing private clients should
emphasize relationships, sound investment policies, and communication.
Private clients differ from institutional clients in

several ways. Because managers of institutional clients typically handle only a portion, rather than all,
of their clients' assets, they tend to be highly specialized and distanced from their clients. Institutional
clients usually use consultants, so asset managers are
unlikely to meet directly with the corporate board.
These managers also tend to be performance, rather
than service, oriented.
With individual clients, a manager needs strong
interpersonal skills. These clients want service.
They want to have confidence in their money managers. Their assets are frequently nondiscretionary,
and a manager needs strong diplomatic skills to convince them of what is in their best interests. One of
the most important things a manager can do for
private clients is to keep them invested and discourage them from panicking out at the bottom of the
market.
A large difference between servicing private clients and institutional clients lies in privacy. All the
information on institutional clients is public, but for
wealthy private citizens who engage money managers, privacy is paramount. Confidentiality is a major
ingredient in servicing those clients.
Whereas institutional clients usually have specialists for the various types of equities-large-,
small-, or medium-capitalization, foreign, domestic-and for the various bonds, a manager of individual clients is expected to be a master of all trades and,
in some cases, a confidante. Private clients' needs
range from generation of income to growth and from
tax, legal, and estate-planning matters to personal
and family matters. Given the range of skills and
services required, private-client managers are often
spread a mile wide and an inch deep. Today, they
face some added complexities. As client educational

levels rise, so do expectations. Managers must constantly strive to educate their customers so they do
not set their investment goals unrealistically high.
Figure 1 prioritizes the differences between the
institutional and individual, or private client, markets. For institutional clients, performance and fees
rank much higher than they do for the individual
investor. Individual investors are more interested in
service; they want communication with their managers. They are interested in building a relationship
with their managers, and they want to have confidence in them. They also want to be involved in the
process. Fees and performance are also important,
but other things are equal to or even greater in importance, particularly involvement in the process
and confidence in the manager.
Investment managers for individual clients must
spend their time focusing on what is important to
these individuals. If confidence, service, and communication are important, that is where their investment managers should focus their efforts. Of course,
all managers want to generate superior returns, but
when investment results temporarily suffer, they
will have good relationships to see them through
these periods.
Private Clients
The assets of households in the United States were
an estimated $15 trillion in 1991-more than twice
the amount of pension fund assets. Table 1 highlights the forms in which these assets are held. The
total shown is an estimate, however, because much
of household wealth is concentrated in illiquid
forms, such as closely held businesses, which are
29
Figure 1. Prioritization of Client-Servicing Needs

Institutional
Clients
Traditional
Private Clients
Highest
Lowest
Service and
Communication
Involvement
in the Process
Fees
Performance
Highest
Reporting
Lowest
Performance
Fees
Reporting
Service and
Communication
Involvement
in the Process
Source: Harris Trust and Savings Bank.
difficult to value. Nevertheless, the potential private

client market is huge.
Much individual wealth is also short term. For
example, the bonds and notes individuals hold are
largely in shorter maturity debt or money market
funds. Twenty years of rising inflation forced many
portfolios into these short-term debt securities,
which has become a problem in today's declining
interest rate environment. This presents a challenge
for portfolio managers in servicing their private clients. That challenge is to blend the short-term assets
with the clients' objectives to manage portfolios in
their best interests. We are now unwinding these
short-term positions, which presents a good opportunity for individuals to reorient their portfolios toward longer term investment objectives.
Not all private clients are alike, and they should
be viewed individually. The following categories
describe some of these market segments and ways to
deal with them:
The ultrawealthy. An ultrawealthy individual or family (those with assets of $50 million and
more) typically has no single investment advisor
relationship but, rather, multiple layers of relationships through consultants, attorneys, and accountants. Often, ultrawealthy clients are beneficiaries of
Table 1. 1991 Financial Assets of U.S. Households

Asset
Deposits in banks
and trusts
Money market shares
Bonds and notes
Stocks
Pension and life
insurance reserves
Equity in businesses
Total
Billions of
Dollars
$3,351
472
1,548
3,068
4,183
2,568
15,190
Percent of
Total
22.1%
3.1
10.2
20.2
27.5
16.9
100.0
Sources: Federal Reserve System Flow of Funds and Goldman

Sachs.
30
trust accounts that stretch for several generations

and could involve charitable foundations. In these
cases, the manager must communicate with multiple
clients rather than one person.
Unsophisticated investors. Great wealth does
not always carry with it great wisdom about wealth
management. In this market, managers may be required to spend time with unsophisticated investors,
regardless of how much money they have. The managers must discuss risk, diversification, and building
a long-term investment plan. This educational process can be difficult because many wealthy people
are used to having people agree with them and do
not like taking advice. Managing their funds often
requires strong diplomatic skills.
High-income, new-money investors. These clients usually have earned their money themselves.
Often, their wealth is in their own names, unlike old
money, which tends to be in trust or insulated from
the clients' direct control. The high-income person is
usually interested in asset growth rather than income
production, whereas the old-money or large-wealth
client is more interested in preservation of assets.
Risk-tolerant versus risk-averse investors. The
wealth accumulators tend to be risk-tolerant investors, and wealth preservers tend to be risk averse. The
accumulators tend to be short-term oriented, while
preservers take a longer, but less aggressive, investment approach. This is sometimes because of age
differences, but it may also be the result of the fact
that preservers are wealthy and accumulators want
to become wealthy.
Entrepreneurs versus investors. These client
groups tend to have different risk profiles and should
be approached differently. Most of these people
should concentrate on the need to diversify among
several investments rather that putting all their eggs
in one basket. Equally, they should be encouraged
to view investments dispassionately and not to fall
in love with them.
The Ultrawealthy Client

As clients become more sophisticated-and particularly as their asset base expands-private clients become more like institutional investors. This is typical
of the ultrawealthy clients. They are more apt to use
outside consultants for the purposes of investment
manager selection, asset allocation, and tactical market timing. Because these consultants have historically served nontaxable institutional clients, they are
more likely to focus on fees and investment performance issues. This frequently presents a dilemma
for investment managers attempting to serve private
clients. Although individual family members may
feel service and communication are important, their

type of management, however, requires tremendous
consultants are concentrating on performance and
effort in coordinating both internal and external resources.
fees. Therefore, the investment manager may find
demands for service and communication expanding
at the same time that their fees are under downward
Other Wealthy Clients
pressure.
The answer to this situation is not an easy one.
Traditional private clients (wealthy, but with less
Our bank has dealt with it by recognizing ultrathan $50 million) are like the ultrawealthy in that
wealthy clients as a separate and distinct market-a
they have income distribution needs, tax planning
hybrid having both individual and institutional serneeds, and investment requirements. These clients
vice requirements. These requirements may involve
do not use outside consultants as much, however,
sophisticated investment expertise, including cash,
and thus rely more on their investment managers to
stock, bond, and real estate management, as well as
develop a sound, long-term investment policy.
limited partnership investing. Filling these requireThe proper investment policy framework is critments may also involve providing specialized adical to accomplishing clients' objectives. Therefore,
ministrative expertise in taxes, the law, credit, and
any serious attempt to service private clients must
reporting.
begin with a clear understanding of those clients'
Our bank has created specialized teams that coobjectives as well as their tolerance for risk, current
ordinate the activities needed to service these ultraincome requirements, and possible principal needs.
wealthy clients. We have an internal coordinator for
Only then can a reasonable investment policy frameeach of these major relationships to deal with tax,
work be developed and the proper asset allocation
investment, and various estate-planning teams. The
mix determined.
investment manager does not necessarily manage all
Managers must communicate regularly with
the money but may coordinate the investment mantheir clients. They must be willing to meet with
agement activities outside the organization, includthem, call them, write them, and communicate in
ing hiring managers for specialized investments
ways that continue to revisit the critical issue of
such as foreign assets, venture capital, and partnerinvestment policy. Managers should thoroughly unships.
derstand their clients' objectives and be able to exFrequently, when there are multiple relationplain to them the plans for achieving these objectives.
ships in a family, a partnership is an exceptionally
They should keep their clients focused on these longgood way to arrange an investment because it allows
range plans so they do not panic or react to shortfor the flow of money in and out but limits liability.
term market events.
A partnership is not always easy to arrange, howListed below are some broad investment policy
ever. We had a situation that required us to organize
issues managers frequently must deal with in trying
a reporting structure for a large family with many
to arrive at a correct asset allocation mix. This list is
different underlying relationships. The purpose was
not necessarily complete. Not only is the world conto combine all of the disparate management funcstantly changing but also new techniques for better
tions that were being carried out at various places
assessing and measuring risk and expected return
around the world and arrange a system of centralare being developed.
ized reporting. This was done through a master trust
Income needs. A client's income needs are
arrangement, but it also had to be integrated with our
important. The higher the current income level the
tax department because of the need to keep track of
client requires, the less likely the manager is to gamer
the individual taxable entities as well as capital gains
long-term growth from the portfolio.
and losses and income; those functions usually are
Risk tolerance. The degree of client risk tolernot required of an institutional firm.
ance is important but hard to pin down. We use a
If an investment manager can provide this level
scenario-type discussion with our clients to assess
of service, make clients aware of it, and satisfy client
their risk tolerance. Most clients have difficulty anneeds, the downward pressure on fees can be alleviswering vague questions such as, "What would your
ated and an above-average fee can be charged. Frereaction be if the market fluctuated up and down 10
quently, this level of service is one the competition is
percent with respect to the long-term mean?" Talknot able to provide. Although managing the investing in absolute terms tends to work better than using
ments of ultrawealthy clients tends to be very much
statistics or percentages. "How would you feel
like managing the investments of institutional cliabout your $1 million account declining by $100,000
ents, managers can still differentiate themselves by
in one year if it were to grow long term at a 10 percent
servicing those clients in a very individual way. That
rate and at the end of 20 years may look like this?"
31
Individual clients are interested in how much money

they have made or lost, rather than the percentage
change.
Time horizon. The investment horizon is an
important consideration because regression to the
mean exerts a powerful influence as the holding
period lengthens. Managers should remind clients
of this phenomenon and encourage them to take a
long-term perspective.
Liquidity need. Liquidity needs can be a
major constraint on achieving long-term results, particularly if large unrealized gains or illiquid investments are involved. Care should be taken to provide
sufficient funds for expected needs. Too much liquidity, however, can penalize longer term growth or
current income because the manager may be forced
to stay in short maturity bonds and away from
smaller equity issues.
Legal constraints. What does your client
allow you to do? What does your client want? What
does the underlying governing document permit
you to do? Although some older documents have
restrictive conditions, trust documents recently have
become much more reasonable. In many states, trust
law is moving toward a modern portfolio theory
approach, which recognizes the portfolio as a whole
instead of simply considering the riskiness of each
individual security on its own. Evolving changes in
the law will help investment managers better serve
their clients by permitting them to structure portfolios more efficiently toward achieving their
customers' investment goals.
Other factors. Other factors that should be
considered include the age of the client (an indication
of the duration of the account) and the account size
relative to the client's total assets.
These factors can be "scored" to arrive at a
stock/bond mix that is then refined based upon longrange projections for stock and bond returns. This
approach to the asset allocation question can be applied in a broad manner or with the advent of appropriate microcomputer software; using the newer
techniques of measuring risks, these questions can be
dealt with more efficiently and in great detail.
Communication
Serving private clients involves not only setting objectives and investing well but also communicating
with them. Emphasis on what is normal valuation,
where the markets are now, and why they are in that
position is a good way to communicate broad investment thoughts to your clients. Perhaps the current
economic environment has convinced you the secular return on large classes of assets has changed. For
32
example, many people today have come to that conclusion about real estate. The same may be true for
bond returns, because we may be in an extended
period of stable inflation. The manager's assessment
of the economic environment and valuation of the
capital markets may temporarily influence his or her
overall asset mix away from the long-term policy
position. Our bank tends to identify a normal mix
for a given investment objective. If we deviate from
that normal mix, we identify the change as a deviation from a long-term normal position and clearly
communicate the reasons to our clients.
As mentioned earlier, communication with clients is important not only because it is an opportunity to report what has happened but also because it
offers the chance to revisit long-range goals and to
educate them. We spend a great deal of time holding
seminars, writing articles on topical events, calling
our clients, and otherwise keeping in touch with
them. These efforts are important in building and
maintaining a relationship. Without a relationship,
the connection between clients and managers will
deteriorate, particularly in times of rocky markets.
We also believe educating ourselves is important. Although we do not require the Chartered Financial Analyst designation, we require our people
to try for it, and it has become an important factor in
our hiring process. We try to educate our administrative personnel as well by encouraging them to go
through the Chartered Financial Trust Administrator program.
Legal Developments
Staying abreast of changes in legislation affecting
trusts is critical in managing the assets of many
wealthy clients. For example, Illinois recently
amended its Principal and Income Act to permit
more of an Employee Retirement Income Security
Act approach to managing individual investments.
This means the entire portfolio is assessed for risknot the riskiness of a single stock but the marginal
addition to the portfolio's risk by adding or removing one issue of that stock. This approach allows
portfolio managers to measure portfolio risk better.
The new Illinois law also deals with the preservation of "real" capital. The total nominal return is
not what matters; what matters is the return after
inflation is deducted. Part of the process in servicing
individual clients should be directed toward informing them about returns and what constitutes "real"
preservation of principal and income.
Another change in the Illinois law concerns the
hiring of outside agents. The market for investing
has become increasingly complex. An individual
manager cannot hope to provide all of the required

investment services. Hiring outside agents and compensating them reasonably is now permitted under
the Illinois trust law.
Conclusion
even lose money on certain transactions if we believe

it is in the best interest of our client and if we are
convinced it will result in a stronger and ultimately
more profitable relationship in the long run. This
attitude will payoff, because the relationship over
time will be a strong and a sound one.
Develop asound investment policy, and reinforce

that policy whenever you have the chance. Review the
That means talking and listening to your client.
building blocks-what has and has not changedand keep working on it, because that is probably the
most important part of a long-term relationship.
Adopt a relationship, as opposed to atransaction,

mentality. With the mergers that have occurred,
Keep communicating, especially during the

tough times. Although we have enjoyed a decade of
many institutions have transaction-oriented functions blending with the investment management operations. This could make for pressure to make a
transaction to gain a short-term fee. Nothing could
be worse. We emphasize the relationship. We may
near-unparalleled returns, we will not always have

rising markets. The ride has been great, but it will
not last forever. Keep talking to your clients and
work on improving the relationship, because it will
payoff as the market slows, which it inevitably will.
In conclusion, I offer four pieces of advice:
Understand what makes each client different.
33

Brian A. Murdock
David L. Mead, CFA
Question: How does a portfolio
manager deal with educating
new business prospects regarding
realistic expectations without risking the sale of the new account?
Murdock: Dealing with client
expectations is a balancing act.
You want to try to educate the client during the sale, but you also
want to get the business into your
firm. Potential clients are amazingly receptive to a logical approach. I try to educate them as
much as possible during the preclient period and then continue to
work on that relationship over
time. If a client's expectations are
extremely out of line with reality,
we will not accept the account.
Mead: Make sure clients' investment parameters are compatible

with the expectations they have
for performance. When they are
not, we are prepared to reject
those accounts.
Question: Please comment on
how you deal with chronic trust
industry problems such as officer
turnover and lack of entrepreneurial mentality.
Mead: The entrepreneurial mentality has suffered in most large

organizations, not just the trust industry. We are subject to the
same staff turnover problems as
other institutions. Our approach
is to pay our people competitively and, more important, to empower them to change policy.
Our view is that the portfolio
manager is the key person in the
organization, because that is the
contact point with our clients. Because it is the client's voice that
ultimately must be heard, the
34
manager should have the most to

say about any relationship whenever a client contacts the institution. From a textbook standpoint,
this is called a pyramid standing
on its head, which is the wayan
organization should be structured. The risk is ending up with
a star system and getting very dependent on one individual. Institutions must accept that risk, because if they are going to service
their clients and maintain low
turnover, people must feel as if
they have a major input into the
client relationship. They must
also be paid fairly.
Question: Because private clients are more concerned with
total return than relative return,
should portfolio managers become market timers, or should
they try to control client expectations?
Murdock: The last thing I
would do is introduce market timing. Market timing does not contribute much to our total return,
and it is a more risky approach to
handling money. When talking
to clients, I often say, "You are
too top-and-bottom focused.
Let's try to talk about highs and
lows." To that extent, we are timing. I try to pull in my horns a little, however, and not be as aggressive.
Mead: The upcoming trend for

individual investors will be risk
control. Market timing is a lowalpha/high-risk strategy. Therefore, strategies that diversify or
control risk will be more important than market timing. Market
timing, at best, is very difficult to
do, and most of the evidence indi-
cates it does not work. Probably

the best approach is to use techniques that control portfolio risk
by diversifying widely around
the world.
Question: How do you define
standards for measuring performance based on total returns
rather than relative returns?
Murdock: For someone who is
total-return oriented, the relevant
benchmark is the risk-free rate of
return-opportunity cost. That
has been a big problem for the
past 15 years, because money
market yields were at 30-year
lows, not at their historic highs; it
is not such a big problem today.
If you cannot earn the risk-free
rate, then you must fold up shop.
I am content to use that as a
benchmark, because in a historical sense we are back to more appropriate return levels.
Question: How does your firm
handle the distinction between an
investment manager (the actual
manager of the day-to-day portfolio) and the portfolio manager
(the one who sets asset mixes and
manages the client relationship)?
Do you believe that private client
firms can deliver the service with
two separate functions? How can
you expect a portfolio manager to
invest the money effectively and
also deal with all the client relationships?
Murdock: Within our organization, I have the choice of being a
fund manager or a portfolio manager, and I choose to be a portfolio manager. I like the client interaction as a source of information
for me in developing a view of
the world, and it makes the job

more interesting. Our organization always has a relationship person out there, but any portfolio
manager who leaves it to someone else to manage a relationship
is putting an account at risk. We
must manage the relationship
and manage the money, whether
allocating the assets or picking
the stocks. Doing both is demanding, but I am not prepared
to give up one or the other. I
want to be involved with clients
and have that interactive aspect.
I do not think they are mutually
exclusive tasks. If you have a
book of business that is both institutional and retail, the job becomes more difficult because the
types of questions and issues you
are dealing with are not standardized.
Mead: The way you do both

jobs is by working I8-hour days.
You spend a lot of time working
on accounts and traveling to see
clients. I get more done in an airport than I do at the office. Client
contact and portfolio management responsibilities are both important. The job cannot be done
effectively unless you talk to clients and find out what they are
thinking. Taking the investment
responsibilities and talking to clients about investments is the portfolio manager's job. We have administrative officers that deal
with the legal, income, and distribution aspects of any relationship, and that saves a lot of time.
Fortunately, those functions are
separated in the day-to-day activities. We work in teams, and often
two people are working on an account, so both are familiar with it.
Question: Some ultrawealthy
private clients have family offices. Do you service them like
you would an institutional client?
Murdock:
I have only a couple
of clients that fall into that group,

and they are still very muchprivate client oriented. In one case,
we are dealing with one of
America's wealthiest families,
which has many members. I cannot keep track of them all. They
have a family company to include
everybody, but we use a personal
as opposed to an institutional approach.
Mead: We have several relationships like that, and we treat them

both ways. The object is to serve
the client. When clients can best
be served by treating them as institutional clients (funneling
some of the activities through a
master trust operation or even
managing money in an institutional sense), we will do that.
The needs of families-even
those with family offices-can be
quite complex. Dealing with the
family office is like dealing with
an individual. You may be dealing with one hired office manager. In other cases, however, the
family office comprises family
members and outside advisors.
We treat them like individual clients when we can, but whenever
we need to bring the expertise of
the entire organization to bear,
we do.
Question: Do you report performance only on a pretax basis?
Murdock: Historically, we have
reported performance on a pretax
basis. In the future, we will be
presenting it aftertax.
Mead: When taxes are paid at

the account level, performance is
presented aftertax. Otherwise, it
is not.
Question: Do you use nontraditional asset classes-such as venture capital, managed futures,
hedge accounts, and short selling-for private investors? Do
you see demand for these asset

classes from private investors?
Murdock: Private client demand for nontraditional asset
classes certainly exists, and technology will continue to expand
the products that fit this class of
assets and subsequently drive the
demand. Merrill Lynch, however, does not provide investment services in these products.
We are aware of these products
and their impact on the markets
we invest in, but the special skill
required to invest in them is not
complimentary to the traditional
asset investments we make for
conservative clients (who in most
cases do not permit investments
in nontraditional products). Importantly, to succeed in hedging
accounts, shorting markets, or
buying venture capital firms, you
must have the skill that comes
from doing them in a big way.
Our firm's bread and butter business does not lend itself to this.
Mead: We use options in many

individual accounts, but we are
much more limited in our use of
venture capital. Limited partnerships have been used for various
investments, but not widely because they require an extensive
amount of due diligence both before and after the investment.
Question: Do you manage
money for foreign-based clients?
If so, how do their servicing
needs differ from those of domestic clients?
Murdock: The majority of my
clients are international. The
major distinctions in servicing
them, besides accumulating serious frequent flyer miles, are threefold: (1) sensitivity to local customs; (2) knowledge of local markets and circumstances (these clients attach importance to their
local circumstances, which form
35
the basis of their expectations);

and (3) timeliness in responses
and reports (foreign clients feel
particularly removed from the investment process and therefore
have a lower anxiety threshold
about lack of information). In addition, my distinctions between
institutional and private clients
apply. An important exception is
in Asian and Latin American markets, where the distinction between personal wealth and corporate/institutional holdings is
often nebulous.
Question: When do you put a
client into a pooled fund rather
than manage the portfolio individually?
Murdock: Pooled funds are
most obviously appropriate for
clients with insufficient assets to
diversify properly in a separate
account. Additional reasons for
36
choosing a pooled fund may be

the need for specialized investments (e.g., venture capital or
German stocks), which may also
be partially attributable to an insufficient asset base. The other
reason for a pooled fund may be
structural-for example, the trust
document does not permit discretionary management or the plan
document requires a client-driven
menu of investment alternatives.
Mead: We use pooled funds
whenever we feel the client's objectives can be better met by
doing so. We do not view pooled
funds as being only for small accounts. For larger families, we
will often create a pooled fund
just for that family so as to better
tailor its investment activities to
its particular needs.
the management of the money
manager/ attorney / accountant relationship.

Mead: In larger relationships,
close contact with family office
managers, accountants, and attorneys always takes place. In other,
smaller relationships, we encourage such interaction.
Question: Do most individual
clients end the relationship with
your institution because you violate their comfort level or because
of poor return?
Mead: Customers leave for a variety of reasons. The biggest ones
are likely to involve a geographical move or interference from a
spouse or other family member.
Investment returns are occasionally stated as the reason but are
sometimes used in lieu of the real
reason. Excess volatility or fees
are rarely mentioned.
The Value of Specialized Investment Services

Chairman and Chief Investment Officer
Universffy Investment Management, Inc.
Firms require a different organizational structure to achieve success with high-net-worth

individuals. In offering specialized products, firms must balance the cost of each service
with the degree to which the product meets the client's needs and goals.
Managing private client assets seems easy: If you

service the clients intensively and meet their financial objectives, you will have all the business you
want. Nothing, of course, is ever quite that easy.
This business is extremely difficult and holds many
challenges. When servicing high-net-worth individual clients, three basics are needed for success:
Make them feel you really care about
them.
Help them achieve their goals.
Charge reasonable fees.
The process of determining investment management costs can be as difficult to sort through as
deciding what price to pay for an automobile. The
automobile has a manufacturer's suggested retail
price, but what a consumer actually pays often bears
little relationship to the suggested price. The charges
for the automobile's features are also difficult to estimate and can vary widely. In the investment management business, determining the initial servicing
price is difficult, and estimating the costs on an ongoing basis is even more difficult. The price or cost
is only part of the equation. Meeting the client's
investment goals and other needs are also critical
components.
This presentation will focus on the prices for
various investment products and the value-added
services to expect from those products. I will also
discuss some experiences we have had at Templeton
in marketing high-net-worth individual services.
As seen in Figure 1, almost half the assets of
high-net-worth individuals are in bonds and stocks.
Although some of the stock is in privately held companies, the remaining assets are available for professional management. Currently, banks manage most
of the assets of wealthy individuals, but perceptions
are changing. My parents always thought banks
were safe and the stock market was risky. The "baby
boomers" believe that the banks are risky and the
stock market is safe. In the next decade, almost $7
trillion will pass from my parents' generation to the
next. This will greatly affect the investment management industry.
Economics of Investment Management

Some segments of the investment management business are very profitable. For example, pretax margins average 46 percent in the institutional business
and 37 percent in the mutual fund business (see
Table 1). The high-net-worth individual business is
less profitable and requires a higher level of personalized service than mutual funds and smaller sized
accounts. For the investment manager, servicing individuals means spreading higher costs over a lower
amount of revenues. Development of a successful
high-net-worth individual business will require
some significant changes in company management.
One important change is the method we use to
manage portfolios and communicate with our clients. Servicing accounts and building relationships
are critical to gathering assets. A portfolio manager
with 20 large portfolios can afford to spend time
building relationships. One who has 100 or more
small accounts does not have that time. Can one
person both service accounts and effectively manage
a large number of portfolios?
Acquiring assets is a significant cost factor in
operating a money management firm. A high-quality distribution system for gathering assets is critical
to the establishment of a flourishing business. The
proper combination of the investment manager's expertise, each client's servicing needs, and the distribution system used to build and maintain the client
37
Figure 1. Where Millionaires Keep Their Money
manager's profitability will be a challenge. Bankers,

insurance agents, and stockbrokers are not necessarily strong sources of business in this market.
Personal
Property
(20%)
Real
Estate
(24%)
Table 2. Advisors Providing Personal Financial

Planning to High-Net-Worth Individuals
Bonds
(11%)
Advisors
Share
Accountants
Attorneys
Stockbrokers and money managers
Financial planners
Insurance agents
Private bankers
Total
44%
29
13
9
4
1
100
Source: R. Prince, Banking in Affluent Businesses.
Product Choices
Source: U.S. News and World Report (copyright 1986), January 13,
1986, based on data from Claritas Partners.
relationship is the key to success.

Much of the individual client business has been
transaction oriented. The salesperson earns a fee
each time a transaction is made. On a long-term
basis, that may not be in the client's best interest.
Consultants have been the major distribution system
for institutional business. They find and refer clients
to us. When you sell to the consultants and get on
their most-favored list, the assets will come in. The
portfolio manager is called to give the final presentation, but the consultants have established the credibility of the firm beforehand. Selling mutual funds
is quite different. They are sold based on superior
performance and advertising, and through stockbrokers.
As shown in Table 2, most high-net-worth individuals select accountants and lawyers as their relationship managers. Finding appropriate methods to
compensate them and maintaining the investment
Table 1. Projected Economics of Investment

Management
(basis points)
Item
Revenues
Expenses
Pretax profit
Margin
Source: Arthur D. Little.
38
Institutional
Managers
1990-91 1995E
35
19
16
46%
32-31
20-22
10-12
32-39%
Mutual Fund
Managers
1990-91 1995E
60
38
22
37%
57-56
40-41
15--17
27-30%
The products available to high-net-worth individuals fall into three broad categories: mutual funds,
commingled funds (a version of mutual funds), and
individually managed portfolios.
Mutual Funds
Mutual funds are vehicles for providing basic
investment services. They are not customized to an
individual's needs, and no extra servicing is directed
to the client. Costs, along with performance, become
critical factors to the mutual fund client. Table 3
shows the results of a study of all the equity mutual
funds in the Morningstar universe-972 of them.
The average expense ratio is 1.53 percent, although
the average expense ratio on the average international mutual fund is 1.86 percent. The average sales
charge for all funds is 3.31 percent. About a third of
the equity funds have expense ratios of less than 1
percent; the average for those funds is 0.75 percent.
Among the 308 funds with expense ratios greater
than 1.75 percent, the average was 2.46 percent.
Some correlation may be present between the
higher expense ratios and poorer performing equity
mutual funds. The average expense ratio for the
top-quartile performers among the 972 funds was
much lower than that of the bottom-quartile performers. About a third of the funds are no-load
mutual funds. Some load mutual funds still carry an
8 percent sales charge. More than half the funds have
12(b)-1 fees. This charge, an ongoing servicing fee
paid to the broker, ranges from 25 basis points to 1
percent annually. It represents a way to keep the
broker or financial planner involved in servicing the
relationship.
Table 4 shows the results of a study on the
fixed-income mutual funds, excluding money market funds. The average expense ratio is less than 1
Table 3. Mutual Funds-Equities

Screen Criterion
All equity funds
Expense ratio < 1.00%
Expense ratio > 1.75%
Sales charge = 0%
Sales charge > 7%
12(b)-1 plan in effect
Top-quartile performers
Bottom-quartile performers
Number of
Funds
972
293
308
336
70
458
Average 5- Year
Return
Average
Expense Ratio
Average Sales
Charge
9.1%
10.3
6.7
8.8
8.6
9.1
14.5
2.8
1.53%
0.75
2.46
1.43
1.10
1.80
1.19
1.80
3.31%
3.18
3.44
0.0
8.29
4.06
3.47
3.20
Source: Morningstar, Inc., 1990.

Note: Excludes money market funds.
percent compared with 1.5 percent on the equity

side. The average sales charge of 3 percent is essentially the same as on the equity side. The difference
in performance for fixed-income funds with lower
expense ratios is significant. About 40 percent of the
funds have an expense ratio of less than 0.75 percent.
The three-year performance of 8.73 percent is far
better than those funds containing a much higher
expense ratio and a three-year return of 5.94 percent.
Again, the top-quartile performers had very low expenses compared to the bottom-quartile funds. In
summary, mutual fund costs can have a vital impact
on performance.
Two items are not included in these mutual fund
cost figures: transaction and tax costs. Transaction
cost is the commission charged to the portfolio as the
portfolio manager carries out transactions. Depending on the portfolio turnover, commission charges
could range between a low of 25 or 30 basis points
annually and a high of 2.5 or 3 percent. Mutual funds
can also have hidden tax costs. Very few people
understand the tax consequences of mutual funds,
which can be significant. Table 5 shows estimated
unrealized gains for 10 mutual funds in 1992. Two
funds had almost 40 percent of their net asset value
in unrealized gains. From the tax effect alone, a client
buying one of these funds would only receive 88
cents for every dollar spent. When managers realize
gains, clients assume the tax liability, even though

they may not have participated in the gains. When
the known costs are added to the hidden costs, a
typical no-load equity mutual fund can cost clients 2
percent or more each year. A typical fixed-income
mutual fund can cost about 1 percent a year. Assuming a 3- to 5-year holding period, the cost of a load
mutual fund can increase an additional 1 percent
annually.
Although a mutual fund meets the needs of a
broad group of investors (the average mutual fund
sale is about $16,500), it may not necessarily do so for
high-net-worth individuals. In most mutual funds,
custom-tailored investment management and servicing are limited:
Investors select the fund that most
closely matches their investment objectives.
Investors have limited access to the investment manager and usually call a servicing representative when questions
arise.
Investors cannot manage the timing of
gains realized in the portfolio.
Commingled Funds
Commingled funds are similar to mutual funds
in many ways, but with some important differences.
Table 4. Mutual Funds--Fixed Income

Screen Criterion
All fixed-income funds
Expense ratio < 0.75%
Expense ratio > 1.25%
Sales charge = 0%
Sales charge > 5%
12(b)-1 plan in effect
Top-quartile performers
Bottom-quartile performers
Number of
Funds
833
309
199
261
171
424
Average 3-Year
Return
Average
Expense Ratio
Average Sales
Charge
7.76%
8.73
5.94
8.28
6.42
7.44
10.27
3.49
0.98%
0.50
1.71
0.81
1.33
1.20
0.72
1.15
3.13%
2.53
3.90
0.00
5.46
3.99
2.78
3.15
Source: Morningstar, Inc., 1990.
39
Table 5. Estimated Unrealized Gains for Mutual

Funds, January 31, 1992
tom-tailored servicing is minimal.
Separate Accounts
Net Asset Value in

Unrealized Gains
(percent)
Fund
Fidelity Select Health Care
CGM Capital Development
Fidelity Magellan
Sit "New Beginning" Growth
New EnglanCl Growth
AIM Weingarten
Merrill Lynch Pacific A
Fidelity Destiny I
Phoenix Growth
IDS New Dimensions
25.2%
18.6
18.0
38.9
38.9
24.4
22.9
24.2
7.7
29.6
Source: Morningstar, Inc.
These funds are not subject to the same regulatory

requirements as mutual funds; consequently, costs of
investment management and servicing fees are
somewhat less. Most commingled funds are sold by
banks, not by brokers or financial planners, thus
possibly eliminating load or other types of sales
charges.
Commingled funds have suffered from perception problems. Some of the best investment people
in the business are in trust companies, but the perception in the marketplace has been that banks may
not be the best group to manage client assets. The
response of the banks has been to form separate
investment management subsidiaries to emphasize
their separation from traditional banking organizations. Banks have probably been more successful at
attracting fixed-income assets than equities, particularly with certificates of deposit. Like mutual funds,
access to the investment manager is limited and cus-
The alternative to pooling client assets into a

single portfolio is an individually managed, separate
account. (In this discussion, I use the terms separate
account and wrap account interchangeably.) The
purpose of a wrap account is to provide individual
customized portfolios. Whether this is actually happening in the marketplace today is a subject for discussion at another time. Separate accounts have
worked effectively for institutions. In the 1950s and
1960s, most institutional investors used mutual
funds. Beginning around 1974, investors subject to
the Employee Retirement Income Security Act
(ERISA) began to switch to separate accounts, and
these accounts now dominate the institutional business.
The concept of a wrap account is to give individuals or small clients the opportunity to have the same
professional money managers as institutional investors. Many wrap programs have made several managers available to their clients. For example, clients
in the Peak program have access to about 15 different
managers; in Shearson's wrap program, clients have
access to more than 150 managers. Most portfolios
are separate accounts as opposed to mutual funds or
other pooled account programs, and most have minimum-sized accounts of approximately $100,000.
It appears that most wrap programs target the
lower end of the high-net-worth individual market.
The average wrap account client usually falls between the typical $20,000 mutual fund ticket and the
high-net-worth individual with liquid assets in excess of $1 million. Table 6 presents a survey on wrap
Table 6. Wrap Fee Industry Comparison
Firm
Peak I
PMC
Rittenhouse
Meridian
SW Securities
Smith Barney Money
Management
Associated Investment
Management
Chase Manhattan
Investment Services
University
Fees Charged
(percent)
3.0 equity
1.8 fixed
3.0
3.0
to 2.5 set-up
2. management fee
3.0
3.0
40
Number of
Managers
Included
Mutual Funds
or Separate
Portfolios
1.5%
15
Individual
2.0
2.0
2.5
1.0
1.5
3.0
15
1
1
Individual
Individual
Mutual funds
fidelity (low load)
Individual
Individual
2.5 set-up
1.0 management fe.e
2.75"
2.5
1.0
3.0
1.0
Source: University Investment Management
"Estimate.
Payout to
Representatives
(gross)
10
1
Mutual funds
8
Minimum
Account Size
$100,000
100,000
100,000
25,000
100,000
100,000
25,000
Individual
100,000
Individual
250,000
programs comparable to our company's. These data

exclude the wrap programs at the five largest brokerage firms, but the information typifies their programs. The fee charges range from 2.5 to 3 percent
on equities and about half that amount for fixed
income. These fees usually cover all costs, including
trading commissions and brokers' sales charges, and
are comparable to the total cost of a load mutual
fund.
Separate accounts can offer the client several
value-added services when compared to other alternative investment programs:
Portfolios can be custom tailored to meet
individual client goals.
Separate account portfolios give clients
more control over their assets.
Portfolios can be structured to meet personal objectives and risk levels.
Regular interaction between the investment manager and the relationship
manager can keep clients actively involved.
As clients' objectives change, their portfolios can be redirected without having
to go through the difficult task of finding
new investment managers.
Separate accounts can have performance advantages.
Clients' timing of the cash flows can
have a more positive impact on performance. Many equity mutual managers
complain that they are forced to maintain higher cash positions and even sell
stocks at market bottoms to meet cash
redemptions.
Separate accounts typically have fewer
holdings in their portfolios, which enables managers to concentrate their investments in their best ideas.
Individual clients can maximize their aftertax return by controlling the timing of
realized capital gains.
Separate accounts can be ideal for clients
who have environmental, ethical, or political concerns. "Socially responsible"
investing has grown from $40 billion in
1984 to $625 billion in 1991. Separate
account clients can direct their managers
to structure their portfolios to reflect
these concerns.
We believe that the development and growth in
wrap accounts from practically no assets in 1988 to
more than $40 billion today (Figure 2) are the result
of strong client demand for value-added services.
The wrap account provides:
Figure 2. Growth of Fee-Based Programs

40 r - - - - - - - - - - - - - - - - - - - - - "
35
c;;
c
0
;3
30
25
; 20
'"...
"0
Q
15
10
5
0
'90
'74
'92
Source: Richard Schilffarth & Associates, Ltd.
Access to top-rated money managers.

Investment management custom tailored to the client's goals.
Exclusivity.
The possibility of higher aftertax returns.
Elements of Business Success

High-net-worth individuals represent the fastest
growing market of our industry. Eighty percent of
these assets are not managed by professional money
managers. This presents an opportunity to add
much value for individual clients. This segment is
significantly different from the mutual fund business, and this market is significantly different from
the institutional market.
Several factors are important in the high-networth market, and they are not the factors most
money managers think they are. Most managers
focus on cost and performance. According to a survey by Fortune magazine, most high-net-worth individuals think track record ranks as the ninth most
important criterion in the selection of a money manager.!' My clients seem more concerned with the
preservation of capital than maximizing investment
return. Banks did not gather the sizable amount of
client assets in certificates of deposit by achieving
the highest rate of return. The cost of investment
services was the seventh most important factor in the
Fortune survey. A top-ranked financial planner
friend of mine has said that many of his high-networth clients realize that some of the cheapest products they buy turn out in the long run to be the most
expensive products they have, and vice versa. Many
high-net-worth individuals understand this concept.
The most important factors in selecting an investment manager, according to the Fortune survey, are:
1Andrew Evan Serwer, "The Wacky Way the Wealthy Invest
and How to do it Right," Fortune (July 1, 1991).
41
Discretion of the investment manager.

nale for owning each company. The report is printed
Manager's style.
on high-quality paper stock and includes color charts
Reputation of the investment manager.
and graphs. Providing this additional information
Quality of the manager's presentation.
minimizes the focus of attention on performance.
The quarterly report is used as the basis for reOur company targets the high end of the high-netviewing the investment objectives of the account. In
worth individual market and the low end of the
addition, we have developed a group of associate
small-institution market segment. Each portfolio is
managed as a separate account, custom tailored to
portfolio managers who work closely with the brothe client's needs. Our typical customer is very conkers to maintain this client communication link. The
brokers and associate portfolio managers can enservative and views risk in terms of loss of capital,
hance the role of the portfolio manager in building a
not relative performance. We offer both global and
long-term relationship by communicating informainternational equity products, as opposed to broadbased equity or fixed-income products, and most of
tion about account activities.
our clients have a long-term investment horizon.
Our firm is structured to offer these services primarConclusion
ily to financial planners at small broker-dealer firms.
We charge a single, comprehensive fee, which covers
High-net-worth individuals differ from typical muall the costs of an account: 3 percent on the first $1
tual fund and institutional clients, and a different
million, 2.5 percent on the next $1 million, and 2
organizational structure is needed to achieve success
percent thereafter. The broker or financial planner is
in this market. It will require a proper balance bepaid half of the fee on an ongoing, annual basis.
tween the cost of the service and the degree to which
To ensure communication between the client,
it meets the client's needs and goals. This balance
broker, and investment manager, we have develmay differ from client to client. If we provide financial guidance, work with unquestioned integrity,
oped a comprehensive quarterly report that contains
a personalized client performance review and a listachieve reasonable financial goals, remain competitively priced, and ultimately foster client peace of
ing of the portfolio holdings. We also describe the
portfolio exposure to the different countries and inmind, we will be successful in the high-net-worth
dustries and provide a brief description of our ratioprivate client market.
42

Question: How does a 3 percent
wrap fee affect the profitability of
the sponsoring firm?
Helsom: It affects the profitability because a significant portion
of the fee is paid to the broker for
gathering assets. Typically, mutual funds and separate account
firms do not pay as high a proportion for marketing costs. The
amount paid to the servicing
agent usually does not include
the cost of marketing materials or
the firm's own marketing staff.
Generally, profitability is lower in
the high-net-worth market. The
study by Arthur D. Little in Table
1 also indicates that profitability
in the mutual fund and institutional business will decline. This
declining profitability is the result
of more intense competition, excess capacity with institutional
managers, and maturing of that
business. The high-net-worth individual business is different in
many ways, and competition will
be intense. This will also put
pressure on operating margins.
Question: What is your opinion
of the future of the wrap program?
Helsom: The future is excellent.
Properly structured, I believe the
wrap account/separate account is
an ideal product for high-networth individuals. Just as institutions many years ago recognized
the value of separate account
management, high-net-worth individuals will also recognize the
value added from this product.
The challenge for the investment
manager is to provide a true, individually managed account (not
the "cookie cutter" portfolios typical of many wrap programs) in
an environment in which costs

are rising and fees will probably
decline.
Question: Are wrap fees negotiable? What is the average wrap
fee after negotiation?
Helsom: A portion of the fee in
the typical wrap program can be
negotiated. The investment
manager's portion of the fee is
usually fixed, and the portion
charged by the custodian or broker is negotiated. One broker told
me that the investment manager
was charging 75 basis points a
year and his firm was charging 15
basis points for custody, trading
commissions, and all other costs.
My experience on the institutional side confirms that very little business is done at the quoted
fee schedule. Our firm does not
negotiate fees at this time.
Many people are critical of
wrap programs because they believe the fees are "outrageous."
First, the fees are reasonably competitive with the "true" costs of
many load and no-load mutual
funds, yet a wrap product can
offer more advantages to the client. Secondly, fees seem to be a
bigger concern for investment
managers than for their clients. If
we continue to focus on fees, we
will miss a major opportunity in
this market. Sales representatives
are an important part of this process and must be adequately compensated for the value they bring
to the process. Investment managers must also add value for the
client. This value-added includes
much more than pure performance. The Fortune survey is useful in determining the key factors
of success in this business.
Question: How do you compensate accountants and attorneys

to keep the relationship active?
Helsom: It is obvious from
Table 2 that these groups dominate the high-net-worth market.
Stockbrokers are responsible for
13 percent of the relationships,
and accountants and attorneys
handle 73 percent of the financial
planning for high-net-worth individuals. Many financial planners
and stockbrokers, however, work
with attorneys and accountants
and become sources of referrals.
The increasing state regulations
are making it more difficult to
market to this marketplace.
Question: Can a package of noload mutual funds be custom tailored to meet a client's objectives
in a more efficient and cost-effective way than a separately managed account?
Helsom: No-load funds can be
a more effective way to meet client objectives if their assets are
not of sufficient size to achieve
the advantages of a separate account. Our minimum account is
$250,000. The differences between mutual funds and separate
accounts were discussed earlier
and will be important to many clients. No-load mutual funds may
not be the most cost- effective
way to achieve personal objectives. The total cost differences
between many no-load mutual
funds are not as great. Equally
important, someone will need
compensation for assisting in the
client's selection of the most appropriate mutual fund. Again,
what may turn out to be the
cheapest in the short run may ultimately be the most expensive
43
over the long term.

Question: If performance is not
of primary importance, should
we concentrate on matching asset
classes to client objectives and
take a passive security selection
approach-especially considering
the tax consequences of active
portfolio management?
44
Helsom: Strategic asset allocation based on a client's long-term

financial goals is a critical element in any financial planning
process and, I believe, more important than performance. The
role of marketing agents-and
the principal justification for
their part in this process-is to
help clients match appropriate
asset classes. The other responsibility of marketing agents is to

identify those investment managers within the appropriate asset
classes that can add more value
than a passive approach. The performance objectives should be to
maximize clients' aftertax return
within appropriate risk parameters.
Investing in Municipal Bonds for Private

Clients
Managing Director, High Net Worth/Retail System
Smith Barney, Harris Upham & Company
For the individual investor, changes in the municipal bond industry-including deteriorating credit quality, a drop in short-term rates, and a likely decline in supply-indicate
that fixed-income portfolios need to be rebuilt.
The municipal bond market is enormous-about

$1.3 trillion. To be a successful investor in this market, one must understand its dynamics. I will provide a summary of the recent history, credit trends,
portfolio considerations, and the current market environment for the municipal bond market.
Recent History
A review of the recent history of the municipal bond
market can yield an extraordinary number of portfolio strategy ideas. Understanding what drives supply and demand in this market is particularly important.
Tax reform has had the biggest effect on supply
and demand in the municipal bond market during
the past 10 years. Prior to tax reform, this market was
dominated by corporate investors, although some
individuals participated. In 1984, out of a $500 billion market, households owned $224 billion of municipal bonds and mutual funds owned another $19
billion. Today, out of $1.1 trillion in long-term municipal bonds, households own $578 billion directly
and $161 billion through bond funds.
At the time of tax reform, many observers predicted the demise of the municipal bond market,
pointing to the lack of corporate demand for municipal bonds and predicting that issuers would be unable to access the market. To paraphrase Mark
Twain, however, reports of our death were greatly
exaggerated. Even though this market has only one
sector and the kinds of bonds that can be issued are
subject to some constraints, the municipal bond market has provided an exciting roller coaster ride during the past few years. My estimate for total new
issue volume in 1992 is roughly $230 billion, up from

about $170 billion last year and from the previous
peak of $207 billion in 1985, which included many
phony deals rushed to market to beat the tax law
deadline. This will be an extraordinary year in the
municipal bond market.
The growth in municipal bond ownership has
been in the household sector, directly or indirectly.
Two sectors that had been important in the municipal bond market have virtually disappeared from the
market. Commercial banks are now gone because
they can no longer deduct their costs of carrying
municipal bonds, except for the 2 percent of the
market that is bank-qualified bonds. Commercial
banks are way down from their peak ownership of
$232 billion; they now own $97 billion. They have
unloaded more than $100 billion of municipal bonds
since 1984 because of tax reform. Property and casualty insurance companies are theoretically still in this
market but have been discouraged by the alternative
minimum tax; three-quarters of their nontaxed income is subject to this tax. The horrendous underwriting experience they have had during the past
several years has further reduced their capacity to
own municipal bonds.
Given that this is only a one-sector market, will
the household sector be able to handle $230 billion
worth of supply? Some pundits say no, but several
considerations may offset that judgment. For example, after the stock market crash of 1987, many investors with cash wanted to invest only in fixed-income
securities. For the typical investor in a taxable account, that means municipal bonds almost exclusively. Currently, the yield on municipals is high
relative to the aftertax return on taxable investments,
45
making municipal bonds attractive.

Another factor that has boosted demand for municipal bonds is the extraordinary collapse in shortterm rates. All growth in bond ownership in the first
half of 1992-the net change in bonds held (bonds
purchased minus bonds maturing or called and
bonds sold)-has been on the bond fund side. Bond
funds added $24 billion in municipals on a net basis
out of an increase in bonds outstanding of $24.7
billion. Individuals reduced their ownership of municipal bonds during the first half of this year by just
more than $1 billion, so they have not added to their
portfolios on a net basis.
The dichotomy between the behavior of funds
and individuals is related, I believe, to two different
kinds of "rate shock." The rate shock smaller investors experienced as short-term yield collapsed (e.g.,
certificate of deposit rates went from more than 10
percent in 1988 to 2.7 percent currently) has caused
them to search for higher yielding investments.
They have tended to do this through packaged products, which have produced the greatest bonanza for
bond funds in the history of the industry. Individual
investors who bought bonds directly have watched
their portfolios collapse, not only because rates are
so much lower than a few years ago but also because
they have not aggressively put that money back to
work. I call them the "wait for eighters." Their
philosophy is, "I got 8 percent last year, and I will
wait on the sidelines until we get back there." Although that has been the worst thing to do, it has
been a very common phenomenon among individual investors.
Compounding this pattern was the "bond-call"
phenomenon. Of the $1.1 trillion of outstanding municipals, an estimated $50 billion will be lost to bond
calls in 1992 and another $200 billion will probably
be lost by the end of 1995 or early 1996. That loss, in
and of itself, has caused many investors' portfolio
structures to collapse. Much of the bond portion of
these investors' portfolios is really near-cash, because the average maturity on a call-adjusted basis
for the typical investor's portfolio has declined
sharply. Investors who were buying 20-year-plus
bonds in 1980 now own 10-year maturities with a Ito 5-year call date. In many cases, they have not
taken significant steps to restructure for several reasons: They do not like the level of rates, they have
unrealized capital gains they are unwilling to take,
and they are unwilling to give up that wonderful
coupon income. They think, "Why should I give up
a 10 percent bond due in a year to buy a 6.25 percent
bond due in 18 years?" That type of action seems
incongruous to the typical investor, even though it
may be the right decision to make.
46
Thus, bond funds have been the dominant factor

on the demand side in the municipal bond marketespecially on the long end of the curve-but the
typical individual investor has not put his portfolio
back into good working order again. Once that occurs, individual investors will become a very important source of demand. Portfolios will be rebuilt
whether rates stay where they are, increase, or decrease. People cannot sit too long with cash while
bonds are being called before that cash begins to burn
a hole in their incomes.
Although I am optimistic that the demand side
of the municipal bond market will be in very good
shape going forward, an impending shortage of
bonds is just around the corner. Municipal bonds
have been cheap by any historical measure relative
to current taxable instruments. The demand for municipal bonds is relatively inelastic, and the supply is
extremely elastic as rates come down. This is especially true when rates come down into territory that
we have not seen for a long time; long-term rates are
at levels not seen since about 1979.
One aspect of municipal bonds that is different
from everything else in the fixed-income market is
advanced refundings. In an advanced refunding,
issuers sell new, lower yielding bonds prior to the
initial call date on outstanding bonds and place the
proceeds in an escrow account, with the proceeds
used to retire the old bonds once they become callable. Prior to that date, two dollars worth of bonds
are outstanding for each dollar of initial bond proceeds. Until the call date, the refunding bonds and
the new bonds are outstanding together, which absorbs an enormous amount of cash, as is happening
now. In 1992, $230 billion worth of bonds will be
created, with about 47 percent of that, on a year-todate basis, consisting of refundings. That supply of
paper will disappear as these funded bonds are
called, and at some point, net new-issue supply will
plummet from current levels.
People tend to believe that the current enormous
supply of new issues must mean that infrastructure
is being rebuilt, but that is not happening. Excluding
the advanced refundings, year-to-date new financings are up 3 percent from last year. Issuers are
facing many problems in getting to the market for
new projects. Thus, the supply of debt to finance real
investment is not growing the way it should, given
the infrastructure and other state and local government needs for capital facilities.
The yield relationship between municipals and
taxable bonds affects the municipal market. Municipal bond yields are high now relative to Treasuries
by historical standards. For the past 12 months, municipals all along the yield curve have traded be-
tween 75 and 85 percent of Treasuries. The enormous supply of municipal bonds this year has put
upward pressure on yield. When all the refunding
volume slows, growth will slow. Volume could easily drop from $230 billion to $170 billion, and if the
rates do not do anything dramatic, volume could fall
to $150 billion two years from now.
The market will adjust to the decline in volume
in several ways. First, yields relative to taxables will
decrease dramatically, approaching or moving
below historical norms. Second, many portfolio
managers and investors will have a hard time finding
municipals that fit their portfolio needs. Managers
will begin to have a hard time matching investors
with bonds that meet their individual needs for maturity, credit quality, in-state exemption, and so
forth. Unless investors are very pessimistic about
trends in interest rates, now is the time to invest in
municipals-during the glut of supply that we are
experiencing this year.
Credit Trends
The credit quality of state and local government
bonds-including general obligation bonds and
lease revenue bonds, certificates of participation, and
other instruments that are indirectly or directly the
debt of a state or municipality-is deteriorating. The
secular erosion in credit quality for state and local
governments began with the current economic
weakness. California's short-term notes, for example, are now rated MIG-2, which is an insult for a state
that historically has had top ratings. Massachusetts
is also suffering from poor ratings, but it is starting
to rebound.
In these cases, the erosion in credit quality is
identified in ratings and is easy to analyze, but some
of the erosion in municipal bond credit quality is not
in the numbers, not easy to analyze, and not systematic in the usual way. This is the type of erosion that
will hurt investors. One reason for this type of erosion is that as economic growth has stagnated in the
United States, the need for services has gone the other
way. Even if the economy had not slowed, however,
the need for more revenues for services and capital
projects would have continued to increase. Health
care needs, the increasing elderly population, and
infrastructure erosion are primary reasons for the
increase in cost. On top of that, the economy, instead
of growing, has made the problems worse because
state and local revenues have been stagnant as the
dependent population has increased.
This somewhat gloomy prospect does not mean
an enormous number of municipalities will default
on their bonds, but credit ratings will be more vola-
tile. The Massachusetts and California experiences

will recur. This situation will require investors to
track the creditworthiness of the bonds they own
more effectively than in the past. Tracking credit
quality was a dying art for most of the 1980s. With
the economy booming and the rising tide carrying all
ships, people forgot that credit quality is an important component in a municipal bond portfolio.
Many problems the municipalities face now will
work out all right. Massachusetts is an excellent
example. After a period in which it should have put
money aside for a rainy day, it had its rainy day.
Then, a fiscally conservative governor came in, tightened the fiscal belt, dramatically cut the level of
services for many members of the electorate, and got
the budget crisis under control. Its low credit rating
now is related to bad economic times.
The story in Philadelphia is similar. Philadelphia came close to default, but it got a strong and
fiscally conservative mayor. When the unions went
out on strike, the city managed to arrive at a relatively
tight agreement. This agreement does not solve all
of Philadelphia's problems, of course, because they
are proportionately larger than those of virtually any
other U.S. city.
Many parts of the United States will go through
a period of budget imbalance, crisis, response, and
turnaround. Today, however, the economy is not
cooperating, and state and local government expenses continue to expand. Because reserves and
rainy day funds have been gutted in many parts of
the country, the margin for error is less.
The importance of the credit side of the portfolio
equation is growing faster than the attention being
paid to it. This pattern is one reason that, for the past
two years, I have been making a case for buying more
essential-service revenue bonds, rather than general
obligation bonds, relative to historical portfolio
norms. Essential-service revenue bonds are tied to
central services-water, sewer, power, and other facilities that do not go through a budgetary crisis
every year. The revenue source can be identified,
and for the better rated issues, coverage numbers are
good. Investors usually do not need to worry much
about these bonds because their credit quality generally does not change much. It only changes if an
economic collapse takes general obligation bonds
down and revenue bonds go, too. This is what we
call the death spiral-the ability to provide services
is destroyed, the tax base erodes dramatically, and so
f{)rth. That has not occurred since the Great Depression. Recently, the numbers have shown an increase
in the valuation of revenue bonds relative to likerated general obligation bonds.
Looking forward, I think credit trends will con-
47
tinue to erode, and more urban areas will have crises,

especially the next time we go into a real recession
instead of this pseudorecession we have been experiencing. Costs will continue to increase. We will
have more crisis-response cycles like those in Massachusetts and California. We will also see a continued taxpayer revolt. We have not had much of that
since California's Proposition 13, although Oregon
passed a spending limitation initiative, which is biting into its ability to provide services. Colorado had
a stringent tax and spending initiative enacted this
year. These measures will not necessarily affect existing state and local credits, but each initiative has
different implications. Some of them grandfather
outstanding bonds, so they make outstanding bonds
better, as in California. Some make the outstanding
bonds worse, and in many cases, the courts have to
decide the implications for outstanding debt.
At some point, the failure of governments to
rebuild their infrastructure and provide services so
businesses can prosper has long-term credit implications that do not show on the surface. In the
long term, businesses need a favorable environment
or they are going to go somewhere else. Ryder is
sending trucks into California on flatbed rail cars
because so many businesses and individuals are
going the other direction. The trucks are going in
empty and coming out full heading in the directions
of Seattle, Oregon, Las Vegas, and so forth. This is
an indication of what can happen when a state government gets into a negative economic and business
climate.
Portfolio Considerations
still optimistic on interest rates in general. We think

the cyclical trend is intact. Although the decline will
not be dramatic from now on, it is not entirely over.
Given that outlook and how cheap municipals are
relative to taxables, we are focusing on the 5- to
I5-year range for much of the money we put back to
work. We are not playing the long end because it is
not as cheap as the intermediate range maturities.
That is because the bond funds own the long end of
the market. I want to concentrate on the many areas
of the curve where the funds are not dominant.
Credit quality erosion is not over, so that is an
important element in deciding what to put into a
portfolio. We include a fair amount of insured bonds
and make sure that the underlying security on those
insured bonds is good. Everything is done in the
context of the need to replace some of the income
being eroded away because of short-term yields declining and maturities collapsing. So we are using
premium bonds to defer some of that pain into the
future in the hope that rates will rebound and we will
be able to get some of that income back. Some investors need these big-coupon premium bonds because
they are running up against their minimum-income
requirements.
One of the ironies of what is occurring in the
market is that we discourage overdiversification because we want the portfolios to be of a size we can
control and monitor easily. A portfolio that has 100
different bonds cannot be effectively monitored.
These portfolios do not give investors any more protection against credit risk problems than those with
20 bonds that we can keep track of and know when
to get out of them. Diversification is fine, but do not
overdo it, or you will lose control of the portfolio.
For the individual investor, changes in the municipal

bond industry mean fixed-income portfolios need to The Current Market Environment
be rebuilt. Many individual investors have done
nothing to respond to short-term rates being down
The trends in the marketplace are important to investment decisions. Quality spreads are currently
by two-thirds. The maturity structure of their portvery narrow because investors are reaching for yield
folios has been decimated by bond calls and by resistance to putting money back to work. At Smith
as yields come down. The bond funds are competing
Barney, despite our efforts to rebuild, almost 50 perfor that extra 0.05 percent of yield. All of this means
cent of the bonds in the portfolios of our high-netinvestors generally should be in higher quality credworth clients will come due within the next five
its because they are not being paid for taking on
years. That is an understatement of how liquid they
credit risk.
are, because it does not include certificates of deposit,
Sometimes municipal bonds are cheap relative
money market accounts, and other cash that does not
to the rest of the market simply because of a glut of
show on our high-net-worth system for one reason
supply. This is one of those times, but it will not last
or another. Furthermore, the typical investor has an
forever. In the middle of July, we had one of the most
enormous amount of near-cash because of short-maenormous buying panics in the recent history of the
turity bonds or imminent bond calls.
market. New issue supply did not start to increase
How the fixed-income portfolio is rebuilt will
again for about two weeks. Because of a big bond
depend on the manager's outlook on interest rates
call date on July I, everybody was afraid that they
and the risk tolerance of the investor base. We are
would not be able to find any more bonds. Conse48
quently, the market had a brief, dramatic rally that

could not be sustained. Those supply-and-demand
considerations are important in our market because
it is not efficient in responding to them. If you understand them, you can add extra value to your
portfolios.
I am optimistic about the future trend of interest

rates. Rates will fall more, especially in the municipal bond market because they are higher than they
should be. Nevertheless, we are being conservative
in what we will put in a given portfolio because of
continuing credit-quality concerns.
49

Question: Is the bond insurance
industry an accident waiting to
happen? Is the insured bond market exposed to a default that a
backstop insurer will be unable to
cover?
Friedlander: Not in my opinion.
The industry will only get into
real difficulty in a long-lasting
secular downturn in credit quality that results in a large number
of defaults relative to the amount
of bonds outstanding. Bond insurance and life insurance are different. In life insurance, when
the patient dies, the insurer pays.
In bond insurance, if the patient
dies, the insurer picks up the interest and principal payments
over a 15-,20-, or 30-year period;
if the patient recuperates, the insurer gets reimbursed.
The bond insurance industry
would be hurt badly by a major
disruption such as those last year
in New York State and in Philadelphia, which made the market
very nervous. A bankruptcy-type
default, which means no payments forever, is more serious
than a payment-type default,
which is more usual in the municipal bond industry. Bankruptcy
has affected some very small
issuers' bonds and a couple of
hospital revenue bonds, but they
were exceptions. The typical insurer can withstand many tempo-
50
rary credit crises before its assets

are eroded away to any large degree. They all have to pass the
Great Depression stress test:
whether they can face as many defaults proportionately as occurred during the Great Depression, lasting as long as during the
Great Depression, with the same
kinds of recoveries as during the
Great Depression, and still have
substantial assets at the end of
that period.
The numbers on insured assets versus reserves sometimes
look scary, but all of these companies tend to stay at the lowest
level of strength they can get
away with and still maintain their
Aaa ratings. They are not paid
for having extra assets not invested in insurance beyond the required minimum, but they never
allow themselves to get below
that minimum. If they do, they
have nothing to sell; they do not
have a product if they are only
Aa rated.
Question: Do you expect an exodus from the municipal bond
funds into individual issues in
the next interest rate cycle?
Friedlander: No. If interest rates
rise dramatically, net monies
going into bond funds will decline and direct purchases of
bonds will pick up. I am not ex-
pecting a 1977-type exodus from

bond funds, however.
Question: Do you consider a
portfolio of high-coupon, prerefunded municipals to be a suitable substitute for a risk-averse
investor looking for better rates
than money market instruments
provide?
Friedlander:
Absolutely.
Question: Are the so-called college education zeros a good investment vehicle for the highnet-worth individual?
Friedlander: To some degree.
Investors with young children
can fund their education with
these bonds, free of federal and
state tax consequences or reinvestment concerns.
Question: Is municipal bond insurance a viable substitute for
credit quality?
Friedlander: Municipal bond insurance is itself a form of credit
quality. All things being equal, I
prefer an insured bond for an issuer with decent credit strength
on its own. I will buy some insured bonds with weak underlying credit strength if the yield
pick-up is sufficient.
Investing in Venture Capital for Private

Clients
R. Gregg Stone
General Partner, PR Venture Partners L.P.
Vice President
Pell, Rudman &Company, Inc.
Venture capital investments are costly, long-term, illiquid commitments. Timing is

important to returns because of the supply-demand cycle in these investments. A
well-constructed portfolio of venture funds should provide above-average returns to
investors.
For purposes of this discussion, I define venture

capital as private equity capital used to finance the
growth or acquisition of a business. This definition
includes management buyout (MBO), leveraged
buyout (LBO), and mezzanine money, but not private equity used for oil and gas, real estate, timber,
and other commodities. Venture capitalists are involved with the creation and the enhancement of the
value of businesses. They are not well understood
by private investors. My objective in this presentation is to provide enough information so you can
make your own judgments, both on our firm's strategy and on other strategies that will come your way.
Categories of Venture Capital
The venture capital industry categorizes venture
capital according to the stage of a company's life
when the venture capital is first applied. These categories, which in practice often overlap, are shown
in Figure 1. The shapes indicate the degree of different types of skills that are needed at each stage.
Seed. This is the early stage of the venture,
so early that no revenues are yet produced. A seed
deal may involve an entrepreneur with a business
plan, or it may be a venture capitalist with an idea
who then finds an entrepreneur to execute it with
him.
Early stage. Revenues have begun, but the
company is still not profitable.
Growth/acquisition. Now that the company is
profitable, the need for financial engineering skills
has grown, and the need for conceptual skills has

peaked.
Acquisition equity (LBO/MBa). The company has strong financial skills and does not specialize by industry.
Mezzanine. The venturer is no longer involved in operational or strategic corporate decisions; it is a true financier.
Obviously, the early stages require considerable
company-building skills. In the later stages of company life, financial engineering becomes more important. The company-building skills of the seed
venture capitalist-writing a business plan, raising
early-stage capital, getting a lease signed, and finding a bookkeeper, for example-become irrelevant in
the later stages of the firm's life. In its lifetime, a
company may be funded initially by seed venture
capitalists, then by a growth firm, and ultimately by
a later stage venture capitalist who sells to an MBO,
which takes out the prior venturers.
Venture capital has unique characteristics. Most
importantly, it is a partnership among funding
sources and management. No matter what stage of
investment the company is in, the providers of capital must forge a partnership with management. The
venture capitalists provide money, strategic advice,
and recruiting or management skills and rely on the
management team for the ultimate success of the
investment.
At all stages, venture capital investments are
costly, long-term, illiquid commitments. Leaving
the commitment prematurely is expensive. The
hope is that eventually the investment will produce
51
Figure 1. Skill Sets of Venture Capitalists

Stage
of Investment
Company
Building
Financial
Engineering
Conceptual
Skills
Seed
Early Stage
Growth/ Acquisition
Acquisition Equity
Mezzanine
Source: PR Venture Partners L.P.
above-average and uncorrelated returns-that is, returns that are not closely tied to the S&P 500, growth
stocks, interest rates, gold, or anything else. The
venture capital industry has its own cycle of returns.
History of Venture Capital
and early venture capital stages. The returns were

quite exceptional: funds in that era were registering
returns of 30 or 40 percent a year.
Building on the success of the 1970s, the heyday
of venture capital came in the 1980s. Changes in the
Employee Retirement Income Security Act (ERISA)
allowed pension funds to invest in venture capital,
which added a huge amount of funding. The industry peaked in 1987 with $17 billion under management. The National Venture Capital Association
grew to 640 members. Because of the ERISA change,
the new investors expanded beyond the individuals,
families, endowments, and corporations of the 1970s.
Venture investment was led by pension funds, insurance companies, and banks. The percentage interest
of corporations, endowments, and individuals fell,
although these sources still maintained a fairly
steady commitment to the industry. The investment
focus of the industry broadened to cover all stages of
growth. On the whole, returns were poor to average,
although the top-quartile performance was good.
As a result of the single-digit returns of the 1980s,
the industry has contracted. This trend will continue
during the 1990s until the number of funds reaches
about 400. As Figure 2 shows, equity fund-raising
has declined sharply from its 1987 peak. The investors have changed again. Most of the investment now
is coming from specialized investment advisors,
"funds of funds" established to invest in groups of
other funds, states, pension funds, endowments, and
individuals. The consensus for returns is about 15
percent.
Venture capital has been around for a long time. The

seeds of the industry were planted by the explorers
and the early shippers who raised money from royalty and merchants for their adventures. Columbus
was a venture capitalist. In recent years, however,
exploration has been difficult: Visiting the moon is
too expensive.
In the 1950s, the industry became better defined Industry Participants
and primarily financed by wealthy individuals or
In the 1990s, understanding the new powers in the
syndicates. The early venture capital funds also had
venture capital market and the new industry dynamsome corporate involvement. American Research &
ics
will be necessary to achieve superior returns. The
Development, founded in the early 1950s and conpractitioners
are primarily independently owned
sidered the grandfather of modern venture firms,
saw a $25,000 investment in Digital Equipment turn
Figure 2. Total Private Equity Fund-Raising, 1980-92
into more than $100 million. J.H. Whitney and the
(billions of dollars)
Rockefeller family funds had success on many fronts,
20 r - - - - - - - - - - - - - - - - - - - - ,
including extraordinary success in backing entrepreneurs in the semiconductor industry. Modern venture capital was born from the success venture capi15
talists had with the semiconductor industry and its
computer-related progeny, which were not well understood by the u.s. financial community at that
time.
By the 1970s, the pool of money available to fund
venture capital industry had grown to between $200
......-million and $400 million, largely from endowments
'80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91 '92*
and individuals, although corporations and small
"Estimate
business investment companies were also active in
the 1970s. At this point, the focus was still on the seed
Source: The Private Equity Analyst, West Newton, Mass.
52
venture capital firms. Subsidiary units of larger financial firms have not been successful in retaining
talent.
Nine large, specialized investment advisors and
another six specialized advisors control between 60
and 70 percent of the dollars-largely pension fund
money-entering the venture ca pital industry today.
Most endowments use specialized advisors, called
"gatekeepers" by the venture capitalists. Their existence has changed the dynamics of the industry,
because they effectively channel the dollars entering
the industry. This control has proven to be a mixed
blessing. On the positive side, the advisors, using
their considerable bargaining power, have negotiated more favorable terms and more uniform and
favorable (to the limited partners) partnership terms.
They also have improved the general partners' understanding of the importance of communication
with the limited partners throughout the life of a
fund.
On the other hand, because of the channeling, the
most successful funds have grown uneconomically
large, and many first-time funds are unable to raise
money. The industry is less prone to experimentation now. In recent press, venture capitalists have
been criticized for not doing as many early-stage
start-ups and for not taking the risks they once did.
In the judgment of the gatekeepers, the risks have not
paid off. I am not debating the quality of their judgment; I merely point out that the dynamics of decision making has changed.
Because of the position of the gatekeepers, exiting the companies has become more difficult. One of
the most popular ways for venture capitalists to exit
a company is through initial public offerings (IPOs).
Typically, the venture capital firm does not sell in the
offering but holds its stock and remains on the board
as the company continues to mature. The gatekeepers do not want the venture capitalists to be public
investors and require distributions as soon as possible. Seventy percent of limited partners sell stock
within a month of receipt. The consolidation of limited partners through the specialized advisors has
accelerated the distribution and sale timetable and
has hurt the performance of the venture-backed IPO
aftermarket. This has made exiting trickier for the
small investors, who tend to receive and act on their
distributions later.
While discussing the players in the industry, it is
important to note its reporters. On the premise that
you cannot tell the players without a program, subscribe. The Venture Capital Journal has been in existence, under a variety of ownerships, since the mid1960s and is considered the standard reporter for the
industry. It is in trade magazine format, monthly,

and deadly dull to industry participants. With his
Private Equity Analyst, Steve Gallante has created a
lively, slightly irreverent monthly newsletter. He
does a better job than the Venture Capital Journal in
anticipating industry events. To date, he cannot be
accused of weighing his readers down with details.
_
The Venture Capital Cycle

The bold return predictions for the 1990s that I have
given you are the consensus and probably wrong.
What drives the consensus is the cycle of venture
capital, which is illustrated Figure 3. If venture capital funds are in short supply, as in the 1970s, or if the
funds for early-stage investing are scarce, as they are
now, investors face much less competition for deals.
That means the pricing on deals is better and venture
capitalists have more time to structure a deal appropriately. Also, although the industry has fewer practitioners, these practitioners have more experience.
So, with undersupply of funds generally comes better industry returns, which eventually causes more
money to come into the business, more competition
for deals, and less-experienced venture capitalists;
then, the values go down again. This has been the
history since the 1950s. We are now in, or emerging
from, an era of declining money in the industry.
Figure 3. Boom and Bust

Industry Returns Rise
Supply of Funds Increases
New Competitors Enter
Undersupply of Funds
Less Competition for Deals
Deal Prices Fall
Oversupply of Funds
Marginal Deals Done
Deal Prices Bid Up
Industry Returns Fall

Supply of Funds Decreases
Marginal Players Fold
Sources: Aspen Ventures, John Hancock Venture Capital

Management.
Table 1 depicts the dollars available for investment in the industry as opposed to money raised.
Money raised or committed may take three to five
years to work through the cycle. Fund raising
peaked in 1987 at nearly $29 million. Then, in 1988
and 1989, partnerships began spending more money
than they had raised, thereby lowering the amount
of money available for investments. Money available for investing is at a cyclical low. Therefore, this
should be a good time to invest at any of the risk
capital stages.
53
Table 1. Cumulative Univested Partnership Capital at Year-End, All Funds, 1980-91

(billions of dollars)
Type of Fund
Year
Acquisition
Growth/
Acquisition
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
$0.081
0.177
0.562
0.614
1.692
1.899
3.987
11.929
14.255
16.422
13.010
11.346
$0.083
0.092
0.082
0.753
0.790
0.789
1.895
2.262
4.180
6.169
5.236
4.569
Venture Capital
Mezzanine
Other
Total
$0.616
1.326
2.248
4.198
6.191
6.331
6.475
7.464
7.047
7.401
6.734
5.566
$0.000
0.100
0.075
0.814
1.148
1.589
3.230
6.748
6.433
6.599
5.120
3.065
$0.000
0.000
0.089
0.242
0.234
0.618
0.506
0.457
1.477
1.112
2.192
1.761
$0.780
1.696
3.057
6.622
10.057
11.227
16.095
28.860
33.393
37.705
32.294
26.308
Source: The Private Equity Analyst, West Newton Mass.
Characteristics of Venture Investment

Certain characteristics define venture investment
through all stages and for every medium. Such investments are long term and illiquid, payoff through
capital appreciation, and feature gradual call and
return of capital. Direct investing-the prospect of
putting money directly into a company-must be
considered a 3- to la-year proposition, depending on
how quickly the company matures. More time is
needed for earlier stage companies. The average
partnership life is legally 10 to 14 years if you invest
through other funds. The early-stage funds often
extend their lives as long as 18 years, and the returns
will be bell-shaped in the middle of that lifetime.
Figure 4 examines the bell curves for the actual
returns of the 1970s and the projected returns. As it
Figure 4. Projected Venture Capital Returns
40 r - - - - - , . - - - - - - - - - - - - ,
J:E30
.....o
gpo
--.
....
\
\
....
....
10
....
'-
OL--'----l-----'--_--L_---J_ _L-_..L..:._-L-J
-20
-10
10
20
30
40
50
Internal Rate of Return

- - - 6 Percent Projected Results for
Funds Formed in Early/Mid-1980s
18 Percent Projected Results for
Funds Formed in Late 1980s/Early 1990s
25 Percent Actual Results for
Funds Formed in Late 1970s
54
indicates, there is some hope for future returns.

Even when investing through specialized advisors, venture capital investors are still in for the long
haul. A venture capital investment has no yield. The
early-stage companies usually break even or incur
losses and the later-stage companies are using the
available cash flow to service debt. Because all the
return to venture capital investors comes from capital appreciation, the capital gains tax rate strongly
affects taxable venture investors. If capital gains
rates are pushed down next year, aftertax venture
capital returns will go up accordingly, which will
attract more money into the industry and push returns down again.
Venture capital investments are illiquid and,
equally important, represent a gradual call and return on capital. This is true whether you are investing directly in companies or through a fund. Figure
5 shows a hypothetical fund that achieves a 15 percent internal rate of return over a 12-year period.
Assume that the 100 percent commitment is $1 million, which is called down over a period of four or
five years in the life of the fund as it needs the money.
During the third or fourth year, some early returns
start occurring. The dollars at risk in this hypothetical example never exceed 60 percent of the investor's
capital commitment. That may sound optimistic, but
dollars at risk rarely exceed 80 percent of a fund.
Although the period of commitment is lengthy, the
rate of return is driven by the actual cash flows, not
the commitment.
When considering venture capital for a client,
consider his interest in the process and product, as
well as the rate of return. Singularly unsuited to
venture capital investments are the new-money entrepreneurs who have a low tolerance for passive
Figure 5. Hypothetical Call and Distribution

Schedule
220,..-------------------,
19
'sco..
'
.'
140
100
60
o
U
. ..
.. .. ,
180
/'
...
/'
-----/----,"._--- -
/'
....
-Maximum
Commitment
.. ,
20
0 f--------'--------',z---------j
-20
--60
-100 L---L_ _- ' -_ _--'--_ _-"--_ _-'---_ _L---'
11
Year
- - - Dollars at Risk
Capital Call Schedule
Distribution Schedule

Note: Internal ra te of return
15 percent.
investing. They get excited about getting into a deal

and discussing prospects, but they are not patient
enough to live through the growing pains of a young
or leveraged company. Even with older money that
has been in trust for a while, if the trustees are not
excited about the venture capital process, perhaps
because of their low risk tolerance or because of
general disinterest, the effort will not be rewarding.
Many people get considerable enjoyment out of the
company-building process and can be helpful to the
companies as they grow. These are your candidates.
Methods of Venture Investing

Direct investing takes a fair amount of time. We do
not recommend undertaking it unless you have a
full-time commitment of at least one investment professional. Success in the venture capital industry
requires excellent deal flow, which takes time to
develop. In addition, you must know how to farm
an investment and what skills you can bring to a new
company.
Because of the need to diversify venture capital
among many companies and to have enough capital
to have an impact on those companies, $10 million is
an absolute minimum to create a direct investment
portfolio. You should have absolute discretion over
the committed funds, because it is foolish to back a
company and then find that your resources have
dried up. A direct investment program produces
higher theoretical returns and higher personal satisfaction but no real diversification for your client.
The Wall Street Journal recently quoted Peter

Burris, research director at International Data Corporation, as saying, "This is not something that someone does as an aside or hobby. Venture capital is the
most ruthless area of investing." Bygrave and
Timmons of the Harvard Business School reviewed
the venture capital process and the value added by
venture capitalists and concluded that part-time
money has not been successful in the process. 1
In contrast, Jeremy Grantham of Grantham,
Mayo, Van Otterloo and Company in Boston, a large
institutional investment firm in the public market,
attributes lower venture returns to the higher personal satisfaction of venture investing. He thinks his
investments have bettered and can continue to better
venture capital returns, because investors ultimately
trade psychic reward for financial returns.
Few individuals have the resources to attempt to
construct their own fund of funds portfolios, but an
investment advisor can pool its clients to create a
fund of funds on its own. This approach entails some
securities law problems with regard to broker-dealer
status and Investment Advisers Act issues, but they
do not appear insurmountable. Here again, the size
and the patience of the pool is critical. Understanding the investment objectives of the pool is important. The general partners of successful venture funds
will want to know about the money that is coming
in-whether it can be of use to them, how patient it
will be, and so forth. Thus, the pooling process requires a double sale-to your investors and to your
investments.
One concern in initiating a fund of funds program is access to the better funds. Most elite venture
funds are oversubscribed, continue with their same
partners, and typically do not look for new investors.
Without a personal relationship, getting into any of
the elite funds is difficult. A new fund of funds faces
the prospect of betting on new funds or funds that
are improving their dynamics. This approach will
create more risk and will require more patience.
In lieu of creating your own fund of funds, you
could invest through a specialized advisor. You
would gain diversification and some unique insights
on the public market and the emerging growth companies. Specialized advisors usually charge a 1 percent fee on the commitment through the life of a fund.
This adds up but is not prohibitive. The average
investment in a fund of funds is about $20 million, so
the focus is on institutions; other investors may thus
have difficulty getting appropriate attention from
the funds. Many funds of funds, in my opinion,
1William D. Bygrave and Jeffry A. Timmons, Venture Capital
at the Crossroads (Cambridge, Mass.: Harvard Business School
Press, 1992).
55
overdiversify by investing in 25 to 50 funds. With

them, you may end up being stuck on the industry
average return rather than above it.
Choosing Venture Managers
Figure 6. Fund Strategy
Regional
Focus
Given a decision to invest in venture capital through

venture funds and without the aid of a specialized
advisor, how do you choose venture managers? By
National
getting to know them as well as possible. You cannot
Reputation
Stage
do enough due diligence. You must call on them,
Focus
talk to entrepreneurs they have worked with, talk to
their limited partners, and talk to other venture capIndustry
italists-in short, learn what makes them tick. Look
Focus
hard at the stability of the general partner group.
This appears to be a young person's business. Many
find other things to do after a few years, so very few
groups have developed the attributes we look for in
a company-stability, clarity of purpose, and a tight
vision. Those that do have these characteristics are
legend.
On the more practical side, one of the difficulties
Figure 6 shows how we think about diversificawe have had with individual investors is their undertion. We have built our fund of funds around a core
standable fascination with taxes and K-ls. Most venof national-reputation funds. We get into as many of
ture funds emphasize the investment process and the
these as possible. We are limited, however, by our
institutional investor group, so they are not very
contacts, limited capital, and ability to sell. Around
good at providing tax information on a timely basis.
that core, we have bought funds that are unique,
We have had a difficult time explaining to clients that
even if they do not stand high on a historical rate of
by committing to venture capital, they have commitreturn basis. We decided that funds focusing only
ted to filing their returns no earlier than September
on early-stage investments are not appropriate be15. The funds they are investing in may be using
cause of the difficulty of finding independent followpartnerships beneath them for early-stage compaon capital. Focusing on particular industries pronies. A client may be five to six K-ls down the line,
vides a tremendous advantage in deal flow and deal
and it takes some time to get those out, in which case
review. We also like regional funds. Although not
the manager should give advance warning.
all regions are worth investing in, some regions in the
country have insufficient venture capital and are
Conclusion
reasonably good bets.
During the past three decades, the venture industry
In going the fund of funds route, $10 million
has alternately rewarded its investors with excellent
should permit investing in 8 to 10 funds. That would
and
nondescript returns. Still, a well-constructed
provide access to 300 to 500 portfolio companies
portfolio
of venture funds should provide above-avwithin those funds, a 3- to 5-year calldown schedule,
erage returns and psychic rewards to qualified inand 6 to 10 years (it is hoped) of attractive distribuvestors. This is not an asset class to be overlooked.
tions.
56

R. Gregg Stone
Question: Which industries
have a potential for unusual
growth?
line with private industry standards, so there appears to be

some room for good management.
avoided in the short term? Or,

are the IPOs a sign of something
to come?
Stone: Currently, the bulk of

early-stage venture capital money
is going into life sciences-biotechnology, health care services,
and health care devices. A second area of interest is software.
These areas have proved successful during the past three or four
years. The forays into environmental services, education, and
hardware improvement have not
been successful.
We are working hard to figure out the next areas of growth.
The service sector still has plenty
of room to improve efficiency
through consolidation. We are
musing about real estate management. More than 6,000 real estate
management firms manage 3 million square feet or more, but they
have done a lousy job, so a consolidation strategy is a possibility.
Consolidation will continue
in the medical area, which means
that well-managed and well-capitalized companies will garner
above-average returns. We
would love to find more opportunities in education, which should
be a focus of the national interest.
So far, getting investor confidence and rate of return in this
field has been difficult. Another
area of interest is privatization.
We are looking at methadone clinics and other functions that traditionally have been left to the
states. The margins and their
overhead expense are way out of
Question: The industry funding

rate has dropped from a high of
$17 billion to roughly $9 billion
currently. Is that an appropriate
funding rate, or would an even
lower funding rate produce better
deals?
Stone: This answer involves

two issues. First, the IPO boom
probably did not create much liquidity for the venture capital investors. Half the money raised
was in the life sciences area. Before stocks could be distributed to
the limited partners, the values in
those stocks were crushed. So if
that is a peak, the venture industry did not do well. Second, I
would not time a venture capital
investment by trying to outguess
the IPO market, because that is
too hard to do. If I were advising
someone to start on a venture capital program, I would put money
to work on a steady basis
throughout a two- or three-year
period to catch whatever waves
come in the IPO market.
The biotechnology stocks
have been particularly volatile.
We do biotechnology investments through our fund of funds.
Biotechnology investing is somewhat of a zero-sum game, and
therefore one must be cautious in
IPO season. The companies cannot all be as successful as they
project, but they do represent tremendous science. The companies
are in much better shape than
they were without the IPOs, and
many have more cash per share
than their share price. I am sorry
for the investors who went in during the frenzy and then took the
licking, but ultimately it was
good for the companies.
Stone: The lower the funding,

the better the deals, but between
$6 billion and $9 billion is a workable amount. I had lunch recently with a fellow from Madison-Deerbore Partners, a growth
capital group. It has had to cap a
new fund at $500 million, which
is quite large. It was looking for
$350 million but had requests for
$1 billion because of its record.
This group believes that opportunities exist for growth capital and
leveraged buyouts, but four or
five years may be needed to get
its money to work. That area appears to attract plenty of moneyperhaps too much.
On the other side of the spectrum, early-stage has all but disappeared on the East Coast.
Fewer than 12 funds with money
claim to be early-stage investors.
So there I think we are at a very
appropriate rate of funding.
Question: Should the IPO boom
in the fourth quarter of 1991 and
the first quarter of 1992, which
gave very good venture returns,
be perceived as a peak? If so,
should venture capital be
57
International Investing for Private Clients

Diane M. Spirandelli, CFA
Vice President
Swiss Bank Corporation
Investment advisors face three challenges in offering a global program to US. clients:
educating prospects about the benefits of diversifying internationally, determining the
most suitable global approach for private clients, and meeting the special servicing needs
of individuals.
International investing is often described as nontraway to go because of the structure and liquidity of
ditional. The word "tradition," as defined in the
American Depository Receipts.
dictionary, means customary and established
thought, action, or behavior. People in the United
States consider foreign investing nontraditional be- Educating the Client
cause investing abroad remains a relatively new pheWell-to-do private investors-defined for our purnomenon for investors and money managers, espeposes as having investable assets of $1 million or
cially for private clients. The comfort level with the
more-are
very different from institutional investconcept is not very high. In contrast, non-US. investors.
This
is
particularly true in international investors and money managers are more comfortable with
ment.
Although
private investors are supposedly
the concept and the practice of international investmore
risk
averse
than
institutional investors, focusing.
ing
on
risk
rather
than
return, most of my clients
Swiss Bank Corporation has a long tradition of
focus
on
returns.
Of
course,
when risk-free returns
providing globally invested portfolios for private
are
only
about
3
percent,
fewer
clients are risk averse,
individuals abroad. When we began our private
and this presents a different type of challenge for
client marketing efforts in the United States in 1988,
investment advisors. Individual client risk-return
we had the global investment infrastructure in place,
profiles can and do vary, however, and we need to
so we thought it would be easy. We did not, howbe able to adjust our approach to meet each of those
ever, have a clear understanding of the challenges we
different profiles.
would face in offering a global investment program
The sophistication level of private clients is gento us. clients. These challenges are summarized as
erally much lower than that of the typical institufollows:
tional client. Our challenge is to provide simple and
Educating US. prospects and clients on
logical explanations on the benefits of global diversithe benefits of diversifying internationfication but still apply some of the theories and techally.
niques developed for institutions. We discuss with
Determining the most suitable global or
our clients four reasons for diversifying: risk reducinternational approach for US. private
tion, increased potential for superior performance,
clients.
opportunities to profit from currency fluctuations,
Meeting the special servicing needs of
and expanding investment opportunities.
U.S. individuals when it comes to forAn institutional investor is probably familiar
eign investing.
with the theory illustrated in the risk-return curve in
This presentation addresses these three topics. It
Figure 1 showing portfolios with different proporalso explains briefly how we invest in foreign assets
tions of US. and non-US. equities. The 70/30 split
in our portfolios for individuals. I focus on servicing
between US. and non-US. equities looks fairly opticlients who own investments directly overseas,
mal for most US. investors. Explaining this phewhich many professional investors see as the optimal
nomenon to your private clients is not easy, however.
58
Figure 1. Risk-Retum Benefits through

Diversification
Table 1. Pertonnance in Selected Equity Markets,

December 31, 1991-August26, 1992
20.0
.e
&
.....
0
18.5
17.5
:::l
17.0
Q)
;;
Non-U.s.
Equities
19.0
18.0
."
Country
195
60/40
40/60
80IW\'
u.s. Equities
16.5
16.0
-28.12%
-12.84
-2.6
-1.03
0.72
2.36
9.86
28.34
Japan
Australia
United Kingdom
United States
Germany
France
Switzerland
Hong Kong
Return
Source: Wall Street Journal.

'----'-_L--'-_'----'-_'----'-_'----'----JL.-....l----J
15.0 15.7 16.4 17.1 17.8 185 192 19.920.6 21.3 22.0 22.7
Annualized Standard Deviation
Source: Frank Russell Company, based on data from MSCI.
If you begin talking about correlation coefficients

and covariances, you will lose them quickly. A more
understandable approach would be to illustrate how
much out of sync the world markets are.
Not long ago, investors worried that the global
economies and markets were becoming more closely
correlated. Several papers were written about this
after the 1987 crash. Investors feared that the benefit
of diversifying overseas would decline. In reality,
however, the correlations remain relatively low.
Table 1 shows the performance of some of the major
markets during the first nine months of 1992.
Clearly, they are not highly correlated.
Emphasizing the long-term benefits of diversifying internationally is crucial. Most of our clients
come to us because they recognize the wisdom of
diversifying across different assets and opportunities, although they are not aware of why. Table 2
illustrates the benefits of adding international stocks
to a fairly conservative portfolio. For the past 20-year
period, adding only one-sixth international to a relatively conservative portfolio would have increased
its return and reduced its standard deviation.

Clients should understand the potential benefits
and risks of currency fluctuations. The volatility of
currencies-as recently witnessed in the breakdown
within the European rate mechanism-is virtually
unpredictable over the short run. At Swiss Bank, we
treat currencies like another asset class that is subject
to a separate asset allocation decision within the
portfolios. We try to explain our currency outlooks
and our forecasts over medium-term and one-year
periods. We analyze and explain significant underand overvaluation of the dollar against other major
currencies on a purchasing power parity basis. This
approach can show us longer term trends, but it is
not necessarily helpful for short-term analysis.
The behavior of the deutsche mark/ dollar rate
during the past 20 years, as shown in Figure 2,
illustrates for our clients many useful points about
currency, including:
The erratic but slow devaluation of the
dollar against a hard currency, such as
the deutsche mark, since currencies
began floating in 1972.
The potential for quick reversals of direction, as can be seen in the mid-1980s.
Given the nature of the currency markets, money
Table 2. Benefits of Diversification
Item
Compound annual return"
Standard deviation
Value of$l million investment
(millions of dollars)
T-bills
7.7%
2.6
$4.4
S&P500
Index
EAFE
1/3 Stocks
113 Bond
1/3 Cash
9.0%
12.3
11.9%
17.5
13.6%
24.0
9.9%
8.4
$5.6
$9.5
3D-Year
T-bills
$12.8
$6.6
1/6 EAFE
1/6 Stocks
1/3 Bond
1/3 Cash
10.3%
8.3
$7.1
Source: Ibbotson, Sinquefield.

Note: Cash, stock, bond, and EAFE returns compared with returns for two diversified portfolios.
"1972-91.
59
Figure 2. Deutsche Mark/Dollar Exchange Rates,

1972-92
3.5 r - - - - - - - - - - - - - - - - - - - ,
...
3.0
'0
0
..:.:... 2.5
---to
S
OJ
..c:u 2.0
"5'"OJ
0 1.5
1.0 L------L_---L._--'-_.l...-----'_--'-_-'--_--'----_L.----l
'72
'74
'76
'78
'80
'82
'84
'86
'88
'90
'92
Source: Swiss Bank Corporation.
managers can enhance returns with an effective, active hedging program or a shift between dollar-sensitive and nondollar markets. Active hedging techniques can either help or hurt performance, however.
Also, for private client portfolios, hedging currencies
is costly and makes sense only for sizable portfolios.
Managers should never let their clients believe that
current currency relationships are the sole determinants of global investments.
The easiest understood rationale for investing
overseas is the expansion of world markets. Between
1970 and 1988, the U.s. share dropped from twothirds to one-third of the world market capitalization, as shown in Figure 3. At the same time, the
whole pie has grown significantly, creating more
opportunities on a worldwide basis.
international bond component in the third quarter.

This reflects our current concerns with the instability
of the European currencies within the European
Monetary System.
For the most conservative client, an all fixed-income investor, we recommend investing about 20
percent outside of the United States and Canada.
The income-oriented client is about 30 percent in
stocks, with a significant international stock component-about 15 percent, or one-half of the equities.
This reflects our more positive outlook currently for
foreign markets than for the U.S. market. Even
though we underweight Japan relative to the Morgan Stanley Capital International (MSCI) Europe/ Australia/Far East (EAFE) Index, our Pacific
Figure 3. World Market Capitalization, 1970 and 1988
1970: $929 Billion
U.S.
(66%)
The Appropriateness of International Investing

Our philosophy is that nearly all investors should
invest internationally to some degree. The most appropriate approach to international investing depends on the client. Figure 4 is a risk-based framework for determining the appropriateness of international diversification. If an investor is willing to take
on some risk to achieve higher real returns, globally
invested portfolios fit into that profile.
Identifying an appropriate benchmark portfolio
is important. Table 3 shows global asset allocation
guidelines for four types of investors. The allocations shown are for the third quarter of 1992. Because
of the higher risk associated with the currency impact on international bond returns, the proportion of
non-North American to North American allocation
is smaller in the more conservative portfolios than in
the others. Although the European bond markets
comprise about two-thirds of the non-U.s. bond indexes, European bonds represented one-half of our
60
1988: $8,680 Billion
Source: Frank Russell Company, based on data from MSCI.
Table 3. Asset Allocation Guidelines by Type of

Investor
(based on U.S. dollars)
Figure 4. Framework for Determining the

Appropriateness of Diversifying
Internationally
Princwal
Stabli ity
Low
Risk
Moderate
Risk
High
Risk
Non-U.s.
Equities
Global
Balanced
Global Fixed
Income.
U.s. Cash
Deposits
.Non-U.s.
Bonds
Global
Equities
U.s. Equities
u.s. Balanced
Investor Type/
Region
Equities
Fixed income
North America
Europe
Pacific
Total
0%
0
0
0
Bonds Liquidity
72%
Precious
Metals Total
92
8%
0
0
8
0%
0
0
0
10
10
Income oriented
North America
Europe
Pacific
Total
15
5
10
30
48
8
6
62
8
0
0
8
0
0
0
0
Growth oriented
North America
Europe
Pacific
Total
25
6
19
50
28
7
7
42
8
0
0
8
0
0
0
0
35
0
0
0
0
18
0
0
18
0
0
0
0
80%
10
10
100
71
13
16
100
U.s. Bonds
Source: Swiss Bank Corporation.
component-made up of Hong Kong, Australia,

Southeast Asia, and Japan-was greater than that for
Europe.
For our growth-oriented clients, we have two
approaches. For balanced growth, we recommend
both stocks and bonds, normally about 60 percent in
stocks and 40 percent in bonds. Typically, about 40
percent would be invested outside of the United
States. Again, the equity allocation reflects our current preference for the Pacific Region over Europe.
The same pattern is established in the all-equity approach but with a fairly high cash position, which
reflects our lower than normal non-North American
equity allocation.
Special Servicing Needs

Individual investors have concerns about investing
overseas that may not arise for US. domestic investments. Their investment managers need to address
these fears, particularly in their reporting.
Client Concems
Among the issues clients may worry about with
regard to being internationally invested are turnover, taxes, higher commissions, and performance
measurement.
Turnover. For an actively managed global or
international portfolio, turnover is higher than for
the average domestic portfolio. I warn my clients of
this at the beginning of the relationship. After all,
considering the number of markets and currency
movements on a worldwide basis, opportunities
present themselves very rapidly, which logically
leads to higher turnover than in a normal domestic
portfolio. Although most of our clients accept this,
Aggressive growth
North America
Europe
Pacific
Total
13
34
82
61
13
26
100
53
13
34
100
they need examples such as why it was a good idea

to switch Japanese holdings to Hong Kong in the first
quarter of 1992.
Tax issues. Clients worry about taxes, but
other than the reporting problems, taxes are a nonissue. Withholding at the source-IS percent of dividends for most countries that have a reciprocal tax
agreement with the United States-will not stop people from investing overseas. Reporting the amount
withheld allows clients to take the foreign tax credit
on their US. tax returns, and that is much better than
reclaiming the taxes.
No taxes are withheld on interest on seasoned
Eurobonds, but on certain government bonds, taxes
may be withheld at the source.
Many portfolio managers send clients 1099s at
the end of the year with currency and market proceeds combined. Clients do not like that. They like
to see the categories broken out. Another factor to be
aware of is that investing in foreign markets will have
foreign currency cash consequences from your purchase and sale activity. Selling a foreign currency
cash position back to dollars will result in a capital
gain or loss and generate a 1099 at year-end. Unless
your reporting system can track these amounts and
their associated costs, you or your client may be in
for a nightmare in January trying to reconcile them.
Commissions. Non-US. commissions are
higher than those in the United States, and they vary.
61
This can be a real cost hurdle for an individual client.

We try to deal with this by block trading as often as
possible across individual client accounts. This requires us to have a discretionary relationship with
them within the boundaries of the agreed-upon approach and parameters. Block trading across a number of accounts can save 75 percent of the average
commissions in countries such as Japan, where commissions are still fixed.
Performance. Clients have difficulty
deciphering the performance of their international
portfolios. The manager's investment report must
have performance benchmarks. We have devised
global performance benchmarks representing each
of the four different account types that were shown
in Table 3. Table 4 shows the benchmarks for each
of the account types. The percentages invested in the
U.S. and non-U.S. components reflect what we consider to be a normal reference allocation. The indexes used are debatable. We use the S&P 500 and
EAFE as opposed to the MSCI World Index. One
reason we do this is that our U.S. equities are managed by one specialist and international equities by
international stock specialists. By using both indexes, we can measure their contributions to performance separately.
Table 4. Performance Benchmarks, Global
Portfolios
Objective/
Account
Type
Reference
Asset
Allocation
Fixed
income only
8% cash
92% bonds
Income
oriented
56% bonds
6% cash
40% U.s. bonds
Global Account Benchmark

8% U.s. cash
75% U.s. bonds
17% International bonds
6% U.s. cash
40% stocks
20% U.s.
20% International stocks
Growth
oriented
6% cash
34% bonds
60% stocks
6% U.s. cash
20% U.s. bonds
30% U.s. stocks
30% International stocks
Aggressive
growth
10% cash
90% stocks
10% U.s. cash

45% U.s. stocks
45% Internationai stocks
Note: u.s. cash

U.s. bonds
International bonds
U.s.
International stocks
62
Treasury bills.
Merrill Lynch U.s. Treasury
Intermedia teo
Merrill Lynch Nondollar Bond
Index.
S&P500.
EAFE.
Reporting and Communications

Because foreign investing is confusing to many
clients, managers should avoid overcomplicating the
matter by inadequate reporting. The fastest way to
lose globally invested clients is to cause them to
spend an inordinate amount of time with their accountants. A number of international money managers do not expend enough effort on reporting.
Institutional-type reporting is not going to do it for
individual clients. We have worked on revising the
reporting formats to make them as clear and educational as possible. In our appraisal statements, for
example, we show the foreign currency exchange
rate and the local price, both at the time of purchase
and at the statement date. That can show clients the
currency impact compared with the local market
return on their U.s. dollar-valued holdings.
Investing the time and effort to report accurately
will payoff, so do not leave this task solely to operations or systems people. You know your clients and
their knowledge level, so you must fully participate
in decisions about systems. Make sure the tax reporting is adequate. Also, if a quality-control person
reviews reports and details before they go to clients,
make sure he or she is educated in international
investing; otherwise, the most obvious problems will
slip through.
Client communications and presentations are
challenging when your investment strategy covers
the world. Our top-down approach involves a complex asset allocation process including 10 different
major fixed-income markets, 13 stock markets, and
all pertinent currency markets. Here, we make our
forecasts based on the U.S. dollar. For our international investors, our reference currencies for asset
allocation purposes include the yen, Swiss franc,
pound, deutsche mark, and the U.s. dollar.
Most clients would be bored with the amount of
statistics involved in building such a rationale and
strategy for investing. Given the need to cover the
economic, interest rate, currency, and capital market
forecasts, an in-depth quarterly report is best. Then,
in the personal presentation or meeting with your
client, you can build on that report. Whether in a
marketing and servicing role or even as the portfolio
manager, the global rationale set out in your report
in advance can provide the basis for a more focused
or interesting story about why you are emphasizing
or deemphasizing a particular area.
Conclusion
All too often, the emphasis for us in the investment
industry is solely on the investment process, and we
fail to recognize the importance of a private client's
special needs, especially in marketing and servicing.

The challenges are real, but they are not insurmount-
able. Over time, your clients will be pleased that you

stepped up to the international plate.
63

Diane M. Spirandelli, CFA
Question: Given the high cost
of transactions and custody of international securities, at what
point could a managed-assets account be individually managed
as opposed to using mutual
funds?
Spirandelli: The optimal point is
the $64,000 question. We manage
the portfolios for our $1 million
and above clients, diversifying
them through country selection
and asset allocation. To help
with diversification, I am more inclined to buy issues within those
countries with more characteristics of the country index. For
transaction costs, we try to block
trade, and we do that successfully
most of the time. Sometimes,
such as during the start-up period, block trading is not always
possible.
We offer custody as part of
the package, which is useful because then you can answer those
issues that relate to custody yourself. Problems with an outside
custodian create another level of
problems for individual clients.
the following statement: Investing in foreign markets provides
exposure to country-specific market risk in the short and intermediate term; investing in U.s. companies with significant foreign
sales provides exposure to foreign economies in the long term.
64
Spirandelli: I think that is a fallacy. As an example, the foreign

markets can also be dependent on
the United States. Recent declines in the U.s. dollar affected
the earnings of many multinational corporations abroad-in
Holland, Switzerland, and the
United Kingdom, for examplewhich are closely linked to the
U.S. economy. Nevertheless,
local market factors are still the
main determinants of market performance. If you believe that investing your clients in multinational U.s. companies can achieve
optimal benefits of global diversification, you are fooling yourself.
Question: Because some companies in the EAFE index cannot be
purchased by foreigners, is there
a better investable benchmark for
foreign investment?
Spirandelli: EAFE is the best
known international index, and
of course it is difficult to replicate
for individuals. Some discussion
is occurring about breaking out
the components of international
indexes and looking at regions
and countries on their own. I believe this would be a better approach than just looking at a U.S.
portfolio benchmark and then investing X amount internationally
against the EAFE index.
Question: Without the effects of
the appreciating yen over the
past 20 years, would EAFE have

significantly underperformed the
S&P 500?
Spirandelli: I do not have information on the yen currency

appreciation's effect on EAFE
over the past 20 years, but I do
know that during the 1981-85 period, the yen declined against the
dollar and yet both the Japanese
market and EAFE in U.s. terms
outperformed the U.S. market.
Question: How can we justify
owning unhedged global bonds
in a low-risk portfolio? Aren't unhedged bonds less diversifying
and about as risky as U.S. equities
to a U.s. bond investor?
Spirandelli: It is true, of course,
that unhedged bonds are risky
compared to u.s. bonds. Their
annualized standard deviation
over the past 20 years is between
12 and 13 percent, which is lower
than stocks. From a diversification viewpoint, it is important to
note a low correlation of less than
0.50 against U.s. bonds and only
about 0.20 against U.s. stocks.
Taking this together with a
higher return of almost 2.0 percent annually over U.s. bonds, I
think a case can be built for including nondollar bonds in some
portion for the moderately conservative investor.
Understanding the Tax Constraints

on Private Clients
Vice President and Treasurer
The Jeffrey Company
Because capital gains taxes have such a negative impact on return, a trade must add
substantial excess return-even at very low levels of turnover-to be justified in a taxable
portfolio. Several strategies can be used, however, to reduce the impact of capital gains
taxes.
Why is so little attention paid to the effect of taxes

on portfolio returns and strategies? Academics and
investment managers do not have much of a "taxable" vocabulary. Many of us have read articles on
the influence of transaction costs, such as market
impact, commissions, and investment management
fees, but little has been written about the largest
transaction cost-taxes.
This presentation explains how much taxes matter. If you are a taxable client, this information will
provide the incentive to ask your managers some
tough questions to test their taxable vocabulary. If
you are a manager of taxable accounts, this information will provide the incentive to expand your taxable vocabulary and include it in your investment
process and client presentations. I will review investment strategies that can lessen the influence of
taxes. This information is most appropriate to taxable "pools of funds," but these same strategies are
helpful to all funds because in the process of reducing
taxes they reduce other transaction costs as well.
Relevant Taxes
You do not have to be a tax lawyer to understand
how taxes affect investment returns. The main taxes
that influence investment decisions are the following:
Capital gains tax. The current maximum tax
rate on capital gains is 28 percent for individuals,
estates, and trusts, and 34 percent for corporations.
These rates are the same for both short-term and
long-term gains. President Bush tried to reduce the
capital gains rate, but even at 15 percent, capital gains
taxes would still have a material impact on investment returns.

Dividend tax. For individuals, dividend income is considered taxable income. A corporation,
however, may deduct 70 percent of the dividends
received from domestic companies. This exclusion
results in an effective tax rate on income from this
source of only 10.2 percent. The dividends-received
deduction is not applicable to dividends received
from foreign holdings.
Alternative minimum tax. This tax assures a
minimum amount of tax is paid by corporate and
high-income noncorporate taxpayers (including estates and trusts), who formerly were able to reap
large tax savings by using certain tax deductions and
exemptions. The use of the alternative minimum tax
usually occurs with individuals with large tax-exempt interest income or corporations with large taxexempt income and dividend income subject to the
dividends-received deduction.
State and local taxes. Tax rates vary among
states and municipalities. Their application also varies among different types of owners and classes of
income. Given this diversity, providing much detail
on state and local taxes is difficult. Nevertheless, any
thorough analysis must include their impact.
All taxes create friction to portfolio returns. The
good news is that some of these taxes are discretionary-that is, they are paid at the discretion of the
portfolio owner. The tax that has the largest impact
and yet is almost fully discretionary is the capital
gains tax. The discussion that follows focuses on
taxes on realized capital gains because they are generated by the portfolio manager's trading activity.
65
Also, because principal growth (and thus the capital

gains problem) is more characteristic of stock than of
fixed-income portfolios, I use equity portfolios to
illustrate my points.
Figure 1. Effect of Turnover on 20-Year Aftertax

Growth of $100
350 , - - - - - - - - - - - - - - - - - - - - - ,
300
Impact of Capital Gains Taxes on Returns
00
To understand the impact of capital gains is to first

discover why they are incurred. Most managers
argue that turnover-and thus capital gains-is necessary to enhance portfolio returns. Managers buy
and sell holdings hoping the activity will increase
value over that produced by simply holding a frozen
portfolio. This, after all, is what active management
is about.
Do active managers add value by trading? A
recent article by Lakonishok, Shleifer, and Vishny
concludes that pension fund managers' trades were
counterproductive when turned-over portfolios
were compared to the frozen portfolios. 1 On average, the frozen portfolios outperformed the active
portfolios by 42 basis points when compared over
6-month periods from 1985 to 1989 and by 78 basis
points when compared over 12-month periods.
Their conclusions excluded taxes (because pension
funds are tax-exempt), management fees, and cash
positions, which would have widened the difference
in the two types of portfolios. Other studies have
reached similar conclusions.
If managers have a difficult time adding value
before taxes, what are their chances of adding value
after taxes? Not very good, according to a forthcoming article by Jeffrey and Arnott. 2 Having worked
with Jeffrey in developing the empirical data for the
article, I drew most of what follows from the Jeffrey / Arnott paper.
Unrealized Gains
The value of unrealized gains is often overlooked. Unrealized gains are the portion of a
portfolio's principal growth that has not been realized and diminished by taxes. The longer the gains
remain unrealized, the more valuable they are, because deferred taxes on unrealized gains compound
for the investor instead of Uncle Sam.
Figure 1 shows the relationship between a 20year portfolio's unrealized gain and its aftertax market value at various levels of turnover. The unrealized gain is portrayed by the distance between the
lJosef Lakonishok, Andrei Shleifer, and Robert Vishny, "The
Structure and Performance of the Money Management Industry,"
Brookings Paper, Microeconomics (992):339-91.
2Robert H. Jeffrey and Robert D. Arnott, "Is Your Alpha Big
Enough to Cover Its Taxes?" Journal of Portfolio Management
(Forthcoming Spring 1993).
66
<l)
250
;:l
.... 200
<Il
150
ii
0
N
100
50
L---L_..l..----.L_--l.----L_-L----l_--L.._L---l
10
20
30 40 50 60 70
Annual Turnover (%)
80
90
100
- - - Market Value
-
",'''''''' "'<1
Cost Basis
Unrealized Gain
Source: Robert H. Jeffrey and Robert D. Arnott, "Is Your Alpha Big
Enough to Cover Its Taxes?" Journal of Portfolio Management
(Forthcoming Spring 1993).
Note: Assumptions include a principal growth rate of 6 percent a

year, a capital gains tax rate of 35 percent, and a time period of 20
years.
upper and lower curves. As turnover starts, the

value of the portfolio steeply declines. At zero turnover, $100 at the end of 20 years grows to $321
compounding at the assumed 6 percent principal
growth rate. At 5 percent annual turnover, the terminal market value drops 12 percent, to $284, because of the capital gains tax. At 10 percent and 25
percent turnover, the market values drop to $263 and
$235, or additional drops of 7 percent and 11 percent,
respectively. At 50 percent turnover, the market
value is barely above the value at 100 percent turnover. At more than 100 percent turnover, there is no
further tax diminution, because the cost basis has
been increased by the reinvestment of the aftertax
proceeds and equals the market value.
Figure 1 also illustrates the counterintuitive reality that the marginal impact of taxes is the highest at
the lowest levels of turnover, diminishing thereafter
as turnover increases. Thus, even the slightest turnover can materially affect returns. This is contrary to
what most people think, because low levels of turnover (25 percent or less) are associated with minimal
taxable impact, while high levels of turnover (50
percent or more) are associated with a large taxable
impact. In actuality, a manager with 25 percent turnover has paid more than 80 percent of the taxes that
would be paid by a manager with 100 percent or
greater turnover. This startling conclusion occurs
because the tax impact of trading is a function not of
turnover but of holding period.

Figure 2 shows a curious relationship between
turnover and holding period. Holding period is the
reciprocal of turnover. Thus, at 1 percent turnover,
the average holding period is 100 years; at 2 percent
turnover, the holding period drops to 50 years; at 5
percent turnover, the holding period drops sharply
to 20 years; and so forth. After about 10 percent
turnover, the change in the holding period becomes
small.
Figure 2. Relationship between Turnover and
Holding Period
100 . . , - - - - - - - - - - - - - - - - - - ,
80
passive return. Figure 3 shows how much added

value is required to overcome the taxes at each level
of turnover. The upper curve shows the pretax asset
growth required to achieve the 6 percent aftertax
growth of the zero-turnover strategy (the middle
line). At 5 percent turnover, the pretax growth required to offset the taxes is 6.7 percent, or 70 basis
points more. At 10 percent, 7.2 percent growth, or
120 basis points more, is required. At 25 percent and
50 percent turnover, the required growth rates are
8.15 percent and 8.78 percent, or 215 and 278 basis
points more, respectively. The obvious conclusion is
that even at low levels of turnover, the amount of
excess growth (added value) required to break even
after taxes is substantial and unlikely to be achieved
except in a very inefficient market.
Figure 3. Additional Pretax Growth ReqUired to
Equal Aftertax Growth at Zero Turnover
10 r - - - - - - - - - - - - - - - - - - - - ,
oL_-'c:::==::::I==::i:========:I
o
20
40
60
Annual Turnover (%)
80
100
-------------".
'"
..........................................
Source: Jeffrey and Arnott, "Is Your Alpha Big Enough to Cover
Its Taxes?"
The impact of this "hockey stick" relationship on

aftertax returns is substantial. From the 20-year portfolios shown in Figure I, the aftertax market value
moving from a percent to 5 percent turnover falls 12
percent, from $321 to $284, as the holding period
drops from more than 100 years to 20 years. In
comparison, at 50 percent turnover, the aftertax market value is $222 and the holding period is two years.
The same 5 percent increase in turnover, to 55 percent, drops the market value less than 0.5 percent, to
$221, and the holding period drops slightly to 1.8
years.
Because of this holding period/turnover relationship, it is far more important for taxable investors
to be aware of changes in turnover at very low levels
than at medium to high levels, because once turnover
exceeds the low ranges, nearly all of the tax damage
has been done.
How Much Added Value is Needed?

Figures 1 and 2 suggest that a passive buy-andhold strategy is rewarding for a taxable investor.
This assumes, however, that the active manager's
trades add no value over the assumed 6 percent
2L.-_ _..L-_ _- ' -_ _-----'-_ _----JL-_-----'
20
40
60
Annual Turnover (%)
80
100
- - - Pretax Growth Required to Equal

Aftertax Growth at Zero Turnover
Aftertax Growth at Zero Turnover
Aftertax Growth When Pretax
Growth Remains at 6 Percent
Its Taxes?"
This is only part of the bad news. The lower

curve in Figure 3 assumes the manager incurs the
turnover but does not get any additional return. At
5 percent turnover, the aftertax growth falls to 5.36
percent, or 64 basis points less than the passive return. At 10 percent turnover, the shortfall is 105 basis
points; at 25 percent, it is 163 basis points; at 50
percent and 100 percent, the shortfalls are 193 and
210 basis points, respectively. Because of the size of
the excess growth necessary to offset the taxes and
the risk in an efficient market of incurring the tax
costs but getting no additional return, the passive or
semipassive alternative has considerable merit for
the taxable investor.
67
So far, 6 percent static growth has been assumed

throughout the 20-year horizon period. Intelligent
investors, however, know that if pursued long
enough, a buy-and-hold strategy will result in flat or
negative growth as the holdings mature. Therefore,
some turnover is necessary to "freshen" the portfolio
to maintain its growth. We know turnover means
paying some taxes. This even applies to the purely
passive index funds, because turnover is needed to
adjust for takeovers, bankruptcies, and so forth. For
example, the S&P 500 has averaged 3.2 percent turnover during the past 10 years. Although some turnover is necessary, it must be small to limit the tax
damage-much smaller than most investors realize.
Empirical Evidence
Supporting these conclusions is some interesting
empirical evidence developed for the Jeffrey / Arnott
article by calculating the lO-year impact of taxes on
72 large equity mutual funds. The mutual funds
were all the growth and growth-and-income funds
as classified by Morning Star with at least $100 million in ending net assets through the 1982-91 period.
Figure 4 shows the pretax and aftertax performance
of each of the funds. The calculations include the
impact of both the capital gains tax and the dividend
tax. Also shown are the tax results of liquidating the
fund at the end of the 10 years and paying the deferred tax.
Figure 4. Ten-Year Pretax and Aftertax Growth of $1
Invested in Various Mutual Funds, 1982-91
10 r : - - - - - - - - - - - - - - - - - - - ,
9 - - CGM Capital
8
"Closed-End Index 500"
V.ngu",d
SOD
Windsor
Mutual Funds
Pretax
After Capital Gains Tax'
After Capital Gains and Dividend Taxes'
After Deferred Capital Gains Tax'
*35 Percent Tax Rate Assumed
Its Taxes?"
As benchmarks, the study includes the Vanguard Index 500 and a hypothetical "Closed-End
Index 500." The Closed-End Index eliminates the tax
impact of "redemption gains." Redemption gains
68
are the capital gains any open-end fund incurs to

meet net shareholder redemptions when on any
given day more money flows out than comes in.
They are in addition to the gains realized from
changes in the makeup of the index fund. Because a
mutual fund does not pay taxes, all realized gains,
redemption or otherwise, are distributed to shareholders. The tax cost of the Closed-End Index 500 is
about 47 basis points a year less than the Vanguard
Index 500. The Closed-End Index is what you would
have if you could afford your own index fund.
Of the 72 mutual funds, only 15 had higher pretax
growth than the closed-end fund during this 10-year
period. After capital gains, however, only five had
better growth, and only two of those (Magellan and
CGM Capital Development) had significantly better
growth. The length of the lines above and below the
black diamonds indicates that the capital gains taxes
have a larger impact on mutual fund returns than
dividend taxes. For the universe as a whole, dividend
taxes reduced the pretax return by just 7 percent,
while capital gains tax reduced it by 23 percent. Also,
the after-dividend tax numbers do not consider a
corporate owner's 70 percent dividends-received deduction or that any investor can theoretically structure a portfolio with a low-yield tilt, which further
lessens the impact of the dividend tax.
Although the deferred tax is usually paid voluntarily, its impact is included for completeness to
show the returns if the funds were sold at the end of
1991. Thus, the lower end of each line would be the
resulting growth of each mutual fund after all taxes
were paid. Because index funds have the lowest cost
basis and thus the highest unrealized gains, the two
index 500 funds have the largest deferred tax cost.
This is noted by the length of the line below the white
diamond. Still, only 10 of the 72 funds had better
growth after all taxes than the closed-end index, and
only 12 outperformed the open-end fund.
For individuals, tax deferral can turn into tax
avoidance. Under current federal law, unrealized
gains and their deferred tax are forgiven at death. So,
if an individual sold all his or her securities before
dying, the executor would pay a tax on the realized
gain. If the individual sold none of these stocks
before dying, there would be no capital gains tax
liability and a "stepped-up cost basis" is passed to
the beneficiaries. Although death may not be pleasant to contemplate, it nonetheless increases the value
of unrealized gains.
Strategies to Minimize the Impact of Taxes

So far, I have shown the negative impact of taxes on
portfolio growth, particularly the capital gains taxes.
I also have shown that an active manager must add

substantial excess return, even at very low levels of
turnover, to justify trading in a taxable portfolio.
Several strategies can be used, however, to lessen the
impact of capital gains taxes. These strategies are not
mutually exclusive.
5emipassive Strategies
Semipassive strategies have low turnover and
are typically structured with holdings that can be
held for a long time. Any index fund may be considered a portfolio that can be held for a long time, but
all index funds do not have as low turnover as the
S&P 500, and some can be quite active as stocks on
the margin move in and out of the index. For instance, indexes based on the Russell 2000 have considerably higher turnover than the S&P 500 because
of the upward migration of successful companies
into the higher capitalization Russell 1000.
An alternative is to create a customized index or
portfolio made to the owner's particular circumstances and needs. At The Jeffrey Company, dividend growth is a primary consideration in selecting
and maintaining portfolios. In addition to tilting the
portfolio toward good dividend growth, steering our
ship by the dividend compass instead of the more
volatile earnings compass tends to reduce turnover
and thus taxes, which is why we made this choice.
Realize Your Losses

A second strategy is to realize your losses.
Losses are like money in the bank because they can
be used to offset capital gains, thereby reducing tax
costs considerably. Because of the tax code's carryforward and carryback regulations, offsetting
gains can almost always be found and taxes recovered.
There are three limiting factors in realizing
losses, however. First, the loss must be large enough
that the tax savings will offset such transaction costs
as commissions and market impact. In our situation,
any loss of 10 percent or greater is considered economical. Second, the Internal Revenue Service's
"wash sale" rule does not allow an investor to realize
a loss if the security was bought within 31 days before
or after the sale. Third, losses typically only lighten
the tax problem rather than eliminate it. Most longterm equity holders will have chronic unrealized
capital gains relative to unrealized losses, except in
rare market environments. Therefore, the best way
to think of realized losses is as a tax-free way to
freshen a portfolio by taking offsetting gains on the
old matured holdings.
Interportfolio Swaps
The third strategy can be used by investors with
multiple portfolios and managers. A multiple-manager structure usually encompasses a diversity of
styles. When a holding no longer fits the manager's
style, he typically sells the holding and incurs a capital gain, even though the holding may still be appropriate to another manager's style in the owner's overall portfolio. An example would be a small-capitalization growth stock that becomes a large-capitalization growth stock or a matured large-capitalization
growth stock that becomes a "value" stock. A swap
between portfolios can be used to satisfy a manager's
desire to rid himself of a stock while eliminating the
capital gain. The owner, however, must make it
happen. Managers rarely want to take another
manager's merchandise, especially at what is probablya very low-cost basis. Also, a manager is penalized economically if he does not have the same
amount of money under management after the swap
as before.
Swaps involve creativity. Some managers manage multiple styles under one roof. This facilitates
swaps and migrations among the portfolios. A manager does not have to replace the swapped value in
the particular portfolio because the money under the
manager's roof remains the same (it has just moved
to a different room).
A second way to create swaps is through an
"ullage" portfolio. Ullage is a term vintners use to
describe the empty portion of a cask as the wine seeps
during aging. Wayne Wagner of Plexus Group used
this term in portfolio management to describe the
difference between what the owner gets from the
aggregation of his manager's individual portfolios
and what he would ideally like to get given his own
particular circumstances. The ullage portfolio in this
case is one used to swap with managers. The ullage
portfolio has no particular style and is made up of
pieces that a particular manager did not want to hold
but that still make sense for the owner. Because the
ullage manager needs to work closely with the owner
and the owner's managers, this portfolio is best managed in-house.
At Jeffrey, we save substantial tax dollars yearly
by swapping holdings. Because the managers agree
to the swaps, we can assume their portfolios improve
as a result, although they may argue that the improvement is less than if they had been free to trade
with the market. We argue that this possible foregone improvement is more than offset by the certainty of tax deferral. Time will tell, but our record
to date supports this contention.
69
Overlay Strategies
offset are in the category of those required to maintain the long-term viability of the portfolio, the overlay strategy provides excess return even though the
manager's prediction was incorrect.
Overlay strategies do have costs, including commissions, fees, and collateral requirements. The largest cost, however, occurs if the overlay bets are large,
frequent, and often wrong, thereby impelling the
manager to take offsetting capital gains in excess of
the small amount of "necessary" turnover to maintain the long-term viability of the portfolio. Basically, overlay strategies are similar to conventional
strategies: If they are likely to be wrong, they should
not be used.
Overlays leave the underlying portfolio untouched but place a contrary or hedging bet using
futures (or options or swaps) to tilt the strategy in a
particular direction temporarily. Suppose a portfolio manager with a $10 million portfolio and a $5
million cost is concerned about the market. Liquidating the portfolio would incur a capital gains tax
of about $1.8 million. For this strategy to break even
on an aftertax basis and cover a 1 percent transaction
cost each way, the portfolio would have to fall almost
20 percent and stay down long enough to buy back
in. Furthermore, if the manager's forecast is incorrect and the portfolio did not decline, the taxes incurred cannot be recaptured. Thus, the portfolio's
aftertax total return would be much less than the
market.
Conclusion
Instead of selling the underlying stocks, suppose
the manager sells $10 million in futures contracts on
The adage that you should not let tax considerations
the S&P 500. (For simplicity, assume the portfolio
cloud your investment judgment is wrong. I have
tracks the S&P.) If the market fell 20 percent, the
never understood why it is bad portfolio manageunrealized gains in the underlying portfolio would
ment to let your broker scrape 200 or 300 basis points
decline by $2 million, and an offsetting gain of $2
off your return with transaction costs, yet it is fine to
million (excluding modest expenses of the future
send 400 or 500 basis points to Washington in premacontract) is realized on the futures overlay position.
ture tax payments. The investment strategies I have
After deducting about $0.7 million in taxes on this
reviewed provide practical solutions to reducing the
gain, $1.3 million in "excess return" is produced
impact of taxes, but their implementation requires
above the underlying portfolio. In addition, if the
taxable clients to take a hands-on approach with
overlay bet proves wrong (Le, if the market goes up
managers who have grown up in a nontaxable envior stays flat), the taxable loss on the overlay strategy
ronment. The bottom line is that clients must teach
can be used to offset realized capital gains in the
their managers the "taxable" vocabulary and then
underlying portfolio. As long as the gains being
make sure they speak it well.
70

Question: How do your conclusions change if the passive rate of
return is higher than 6 percent?
Koontz: The higher the passive
rate of return, the larger the unrealized gains. The larger the unrealized gains, the larger the impact
of taxes as turnover commences.
Question: What value does a
manager add in a buy-and-hold
strategy?
Koontz: We think managers can
add value in a buy-and-hold strategy by picking good companies,
with good managements and
good positions in their marketscompanies that are worthy of
holding for a long time. A small
amount of turnover is "necessary," even in a buy-and-hold
strategy; to maintain the
portfolio's long-term viability, a
manager can add value by using
this small amount of "necessary"
turnover wisely.
Question: The Jeffrey / Arnott
article only references mutual
fund performance. Would the results be similar for individual private account returns?
Koontz: The results would be
similar for any taxable portfolio.
The mutual fund data were used
because they were easily available. If you are taxable and you
have turnover, whether you have

a mutual fund or separate account, beware of the sizable tax
bite.
Question: Do your calculations
in Figure 4 include transaction
costs?
Koontz: The mutual fund returns in Figure 4 are adjusted for
12b-1 fees and operating expenses.
Question: Figure 4 considers liquidating the ending portfolios
and realizing all capital gains. Is
that true for Figure 1?
Koontz: Figure 1 does not consider realizing all capital gains, except in the obvious case of 100
percent annual turnover.
Question: Does the assumption
of 6 percent passive return assume perfect knowledge of
stocks' future returns? How low
does the compounded rate have
to go to make taxes unimportant?
Koontz: The 6 percent passive
return assumption was used because it approximates the Ibbotson Associates compound principal appreciation rate of common
stocks for the 66 years ending in
1991. The compound return at
which taxes become unimportant
is zero percent.

the effect of generating losses to
offset capital gains-that is, net
the client to zero annually. Was
this considered in the study?
Koontz: You always should realize your losses to offset gains
when the losses are large enough
that the tax savings offset the
transaction costs. Most long-term
investors, however, have chronic
unrealized gains relative to unrealized losses. Therefore, in reality, netting the client to zero annually is difficult because losses will
not be available as the portfolio
holding period increases.
Question: In Figure 1, your
$320 value after 20 years assumes
no taxes paid. Should the ending
value be $243, which includes the
impact of taxes?
Koontz: The $320 value is the
starting or reference point of Figure 1 and by design assumes zero
turnover and, therefore, zero tax
bite. The $243 value is calculated
by selling the entire $320 portfolio at the end of the twentieth
year and paying the $77 in deferred taxes. We specifically
show the impact of paying the deferred taxes in Figure 4 with the
mutual fund data.
71
Estate Planning and Charitable Giving

for Private Clients
William R. Levy
Vice President
The Glenmede Trust Company
Three aspects of estate planning relate especially to private clients: tools to reduce or
defer tax liability (providing additional funds for investment); methods for establishing
"pools of funds" using lifetime gifts to avoid tax liability; and split-interest charitable
trusts to provide benefits to donors and charities.
Estate plans should be structured so that individuals

can pass on as much of their wealth as possible to
future generations by paying as little tax as possible.
Clients are usually happy to know that their net
worth is growing, until they realize that when their
generation dies, as much as half of what they own
will go to Uncle Sam. By using a little creativity and
taking advantage of the tax laws, most people can
pass a greater amount of their net worth to their
children and grandchildren.
This presentation covers three aspects of estate
planning and charitable giving. First, I will outline
estate planning tools that effectively reduce or defer
tax liability, providing additional funds for investment. Second, I will examine methods for establishing "pools of funds" for one's heirs using lifetime
gifts to avoid tax liability. Third, I will consider how
to establish and fund split-interest charitable trusts
to provide benefits to the donor as well as to the
charity.
Estate and Gift Tax Shelters

Investors must be concerned with the effect of federal
and state transfer taxes. Federal estate and gift taxes
are levied when one individual transfers assets to
another; the rate can run as high as 55 percent on
large estates. The Internal Revenue Service (IRS) has
given us four effective weapons in our effort to avoid
or reduce these taxes:
Unified credit exemption. This allows all individuals, either during their lifetimes or at death, to
transfer up to $600,000 to any individual or group of
individuals, with no federal tax. If properly planned,
72
every couple can pass at least $1.2 million to the next

generation with no federal tax.
Unlimited marital deduction. Since 1982, the
IRS has fully exempted transfers between a husband
and wife from the transfer tax. The only caveat is that
if the transfer is made in trust to a spouse, that spouse
must have full and exclusive use of the income. As
a result, the tax may be deferred until both spouses
have died. Thus, the entire estate of the first spouse
to die can avoid taxation, and the surviving spouse
has the full benefit of the funds until his or her death.
Annual gift tax exemption. Every individual
may pass up to $10,000 to any other individual every
year with no tax. In fact, if a husband and wife join
in the gift using his assets, her assets, or their assets,
they can pass $20,000 to as many individuals as they
choose in anyone year. In addition, they can do this
year after year. Through the years with many gifts,
much of one's estate can be passed on to beneficiaries
tax-free.
Charitable deduction. This is effectively a congressional subsidy to charities. Rather than collecting tax dollars and trying to determine all the worthy
causes in the United States, Congress gives a generous tax deduction to individuals to fund these concerns for them. For income tax purposes, individuals
making charitable gifts can claim a deduction equal
to their effective tax rate (currently as high as 31
percent). Upon death, the deduction can amount to
up to 55 percent, equal to the highest federal estate
tax rate.
To illustrate specific ways to use these shelters, I
will use a case study that addresses some problems
in estate planning.
The Morgan Family

Harry and Marie Morgan have four children:
Bob, Carol, Ted, and Alice. The family lives in a
comfortable Illinois town. Harry, 62, who has had a
successful career as a pharmacist, now owns three
separate stores in the area. Marie, 58, a registered
nurse, worked part-time for a local hospital. Bob, 27,
has an associate's degree in agriculture and is running a dairy farm with his wife and three children.
Carol, 24, earned a degree in pharmaceutical science,
works for a major drug firm in the area, is married to
a successful cardiologist, and has a 2-year-old child.
Ted, 18, is a senior in high school, and Alice, 14, is in
the ninth grade; they live at home with their parents.
Harry was approached by a large national drug
concern to sell one of his three stores for about $1
million to be paid in cash and securities of the buyer.
Harry's cost basis for the store is $50,000. The company also indicated a willingness to purchase the
closely held stock of Harry's company, which owns
the other two stores. Harry and Marie have been
discussing early retirement, particularly since they
want to volunteer their services at the hospital where
their daughter Alice received wonderful care for a
childhood illness.
After the sale of the first store, Harry and Marie's
asset picture would break down as shown in Table 1.
Harry had about $500,000 in liquid assets before
the sale, and he now will have $1.5 million. The sale
of the store, however, involves a built-in tax liability
of $266,000 on the capital gain. In addition, the
closely held business interest of the two remaining
stores is worth $1.5 million with a cost basis of only
$100,000. These businesses have grown dramatically
through goodwill and good location. Harry also has
about $500,000 of life insurance, which he owns; a
$300,000 pension plan; and tangible assets of about
$100,000. Marie has about $100,000 in her own name,
some life insurance, a $50,000 pension benefit, and
tangible property. They have $250,000 in a joint
Table 1. The Morgan Family's Assets
(thousands of dollars)
Asset
Harry
Marie
Joint
Cash/securities
Real estate
Closely held
business interest'
Life insurance
Pension
Tangible/miscellaneous
Total
$1,500
0
$100
0
$250
300
0
50
50
25
225
0
0
0
0
550
1,500
500
300
100
3,900 b
basis = $100,000.
Less tax liability of $266,000 on sale of store.
money market fund, and they jointly own their home

worth about $300,000.
Harry and Marie realize they have not updated
their estate plan for 20 years, never realizing how the
business had grown and increased in value. So they
are also interested in updating documents. They are
concerned about their life insurance and whether it
will be enough to cover both the expected tax liability
and the potential cash needs if they were to die before
they sell their business. It is also paramount that they
maintain their life-style in their retirement and that
they put two more children through college.
Finally, Harry and Marie are concerned about
repaying the debt of gratitude to the local hospital,
which took such good care of their daughter, without
dramatically affecting their life-style.
Guideline Answer
How can Harry and Marie use the antitax weapons at their disposal in an effective way to maximize
their goals? Several tax-saving provisions are available, but they must be planned in advance.
Split assets. First, the family assets should be
split so both Harry and Marie have at least $600,000
in their own names. This way, no matter who dies
first, the estate can take full advantage of the $600,000
shelter provision. Before splitting the assets, Marie
had only $100,000 in her own name. Thus, of the
$600,000 shelter, she could only take advantage of
$100,000. This could create an additional tax to be
paid upon Harry's death if Marie died first. Because
of the unlimited marital deduction for transfers between spouses, the problem can be easily remedied
if Harry transfers $500,000 to Marie. In most situations in which the marriage is solid, this is a simple,
effective solution to a potential unnecessary tax.
Prepare documents. People must have their
wills and trust documents reviewed or prepared by
competent counsel. Many attorneys hold themselves out as being able to prepare a will. With the
constant changes and increased sophistication of tax
law, however, not everybody can prepare a proper
will.
Establish a family trust. To use the planning,
the first step is to establish a family trust at the death
of the first spouse. The first $600,000 of assets is
placed into a family trust, which will allow that
$600,000 to be sheltered from estate tax both at the
first spouse's death and at the second spouse's death;
it will not be taxed until the ultimate beneficiaries die.
This is a very effective shelter. The income from the
trust either can be distributed to the surviving
spouse, the children, or a combination, as determined by the trustee. At the death of the surviving
spouse, the principal would pass either to the chil73
dren or to the grandchildren and may remain in trust

or pass outright. This vehicle has a lot of flexibility,
but the key is to get the $600,000 out of the surviving
spouse's estate so it will pass free of tax at the first
death and the second death.
Establish a marital trust. Assume Harry dies
first with an estate of about $3.5 million. We have
put $600,000 of that into a trust for the family, which
leaves about $2.9 million subject to tax. All tax can
be deferred, however, by putting the $2.9 million into
a marital trust. A marital trust is a temporary shelter
allowing the remaining $2.9 million portion of the
estate to continue to pass tax free until the death of
the second spouse. This trust would also be used to
generate income for Marie for her life. In fact, if
Marie needs principal, the principal can be made
available as well. The key is to prevent the IRS from
getting its hands on the money for as long as possible,
so the family has the use of the money. This twotrust plan is the way most people with estates of more
than $1 million can take full advantage of their unified credit and defer the tax on the balance as long as
possible.
Powers ofappointment. This is a nontax issue,
but it is important for families concerned about the
possibility of property passing to inlaws or children
who may not be able to handle it. Powers of appointment provide the opportunity to take advantage of
some flexibility. For example, by creating the family
and marital trust, Harry plans to treat his four children equally. He assumes that when Marie dies,
everything will go to his four children equally. During the years between his death and Marie's death,
however, the four children may go in different directions, some developing special needs or financial
concerns.
Many clients have children whose lives have not
worked out the way they would like. They are concerned about leaving money to these children. If, for
example, 10 years after Harry dies Marie realizes that
Ted is having a problem with substance abuse, Alice
is suffering from some of the problems of her childhood illness, and Bob needs the money more than the
others, she can exercise her power of appointment to
redirect the family funds at her death. She may give
the needy children more money, and for those who
should not receive money outright, it could be placed
in trust. If they need the money, it is there, but they
do not have unlimited access to it.
When they have developed substantial assets,
many clients are not only concerned about leaving as
much as possible but making sure it is protected.
Clients are also concerned that the children feel they
are loved and treated equally. By use of power of
appointment, the document shows the money will
74
be distributed equally, but the opportunity to change

the distribution, if necessary, remains. This is a very
effective tool, but it must be included in the documents when drawn. It is too late to take advantage
of this flexibility after the documents have been
drawn and the testator dies.
Generation-skipping trust. Where appropriate, the estate plan could also provide for generationskipping tax protection to avoid a substantial tax at
the death of the children's generation, prior to the
property passing on to grandchildren. Since 1987,
tbe government has not allowed people to pass unlimited inherited wealth from generation to generation. The generation-skipping trust permits every
individual, to the extent of $1 million, to pass property from one generation to the next with no additional tax at each generation. Anything more than $1
million will be taxed at each generation, whether or
not each generation has access to the trust principal.
Recent congressional discussions have proposed
limiting both the $600,000 unified credit and the
annual gift tax exclusion, but the generation-skipping tax is probably here to stay because it is focused
on the most wealthy.
Use of living trusts. Another option to consider is a revocable living trust, which would include
the same dispositive provisions as a will but would
also permit lifetime protection in the event of an
individual's disability, privacy for the client and his
or her family, and professional investment management. This suggestion does not save taxes, however.
A living trust is a revocable document in which an
individual creates a trust, usually remaining on as
trustee or co-trustee and often adding a financial
institution or trusted friend as co-trustee. The client
puts most of his manageable assets in trust with the
idea of achieving several benefits, the first of which
is privacy. When either spouse dies, if the assets are
held in a living trust, they are not subject to public
scrutiny. They need not be reported to the register
of wills or the court in which wills are probated.
Because the assets pass outside the will, no one has
to know the size of the estate, and the family preserves confidentiality.
The second benefit arises in the event of a disability. Suppose I have maintained my own assets, have
done my own investments, and kept close control of
my funds. Suddenly, I become disabled. Who will
take over? Some people feel a power of attorney is
sufficient. A living trust gives the trustees the opportunity to continue to manage my assets, pay bills, and
even continue with gift programs. At the same time,
the trust is revocable, so if the arrangement is not
working out satisfactorily, I can end it and take all
my assets back.
The living trust also provides an opportunity for

portfolio managers to manage the client's assets. The
client, whether disabled or well, may not want to
worry about managing the trust anymore.
Lifetime Gifting
A series of noncharitable gifts made over the lifetime
of the giver can be used to create new pools of funds
and also reduce estate tax liability. Several alternatives exist for making lifetime gifts, including annual
exclusion gifts and noncharitable split-interest trusts.
Annual Exclusion Gifts
aries. If the estate includes substantial illiquid assets,

such as real estate or a closely held business, an
irrevocable life insurance trust is the best way to
ensure that sufficient cash is available for the payment of taxes and other cash needs after the death of
the owner, thereby reducing the need to liquidate
other assets in a depressed market.
Split-Interest Trusts
Another opportunity to leverage the value of
lifetime gifts is through the use of noncharitable
split-interest trusts known as GRITs, GRUTs, and
GRATs-grantor-retained interest trusts, grantor-retained unit trusts, and grantor-retained annuity
trusts. This is an opportunity to leverage the gift
when using the $600,000 unified credit gift shelter.
For example, suppose I have real estate worth $1
million. I transfer it to a trust but retain the right to
live there for 10 years. At the end of the 10-year term,
I no longer retain any ownership interest, and the real
estate passes to my child.
What is the value of this gift? When I transfer it
to the trust, the value of the real estate, less the value
of my life interest (which is an actuarial determination), is about $400,000. If I live 10 years, I have given
a $1 million asset that was valued for gift tax purposes at $600,000. Thus, I have leveraged my shelter.
Again, these trusts are fairly sophisticated. They
must be prepared by a competent attorney to ensure
the tax deduction, the proper valuation of the gift,
and the remainder interest.
As already mentioned, individuals may transfer

up to $10,000 (married couples up to $20,000) a year
to as many people and for as many years as they
choose. Annual exclusion gifts can be leveraged in
several ways to take maximum advantage of this
shelter. People will benefit from following several
simple rules in making these gifts. Many people
believe that if they transfer stocks or other appreciated assets to family members, the family somehow
benefits. It does not work out that way. With transfers to individuals, the best gift is cash. If appreciated
securities are transferred to another generation at
their value at the time of the gift, say $10,000 in stock
with a cost of $5,000, the one who receives the gift
will probably sell the asset eventually. When he sells
the asset, however, there is a built-in capital gain,
which reduces the value of the gift.
Another way to leverage this $10,000 gift tax
benefit is by using an irrevocable trust and life insur- Charitable Giving
ance, sometimes referred to as a "Crummey Trust."
Obviously, giving money to charity provides emoThis device creates a large "pool of funds" for investtional rewards. Many clients are philanthropic in
ment, undiminished by taxes at the insured's death.
their daily lives, and they get a feeling of great satisBy placing the $10,000 annual gift in an irrevocable
faction
from these gifts. It may relieve some of their
trust and having that irrevocable trust buy life insurguilt
for
accumulating substantial wealth in the face
ance, upon the death of the insured, the life insurance
of
the
problems
and needs of the world. Philanproceeds come into the trust tax free. This is possible
thropy
also
provides
many financial benefits primarbecause the insured has no ownership interest in the
ily
generated
through
the Internal Revenue Code,
policy or the trust. His only role was being the
which
encourages
individuals
to make charitable
insured, and he has no further interest other than
gifts.
In
some
cases,
clients
have
retired with large
having supplied the money with gifts to the trust. As
holdings
of
stock
with
a
very
low
basis
and very low
a result, the insurance proceeds avoid being taxed in
yield.
They
are
frustrated
because
they
suddenly
his estate.
need
the
income,
but
to
increase
their
income,
they
This scheme involves several technical requiremust
sell
stock
and
pay
big
capital
gains
taxes,
which
ments. First, it requires a properly drawn document.
would reduce the funds needed to generate the inAfter the document is drafted, the insured must have
come by up to 30 percent. Charitable gifts can prono ownership interest in the policy; he cannot be an
vide some relief.
owner or applicant. The policy is applied for and
owned by the trustees. The insured makes contribuSimple Gifts
tions to the trust, the trustee pays the premium, the
Direct gifts of either cash or securities provide
policy proceeds come into the trust at the death of the
insured, and the money is available for the beneficithe donor with an income tax deduction of up to half
75
of the donor's adjusted gross income in the year of

the gift and the opportunity to spread the deduction
for larger gifts over a period of up to five years.
Many donors take advantage of this opportunity to
avoid capital gains taxes on appreciated assets by
giving such assets to a charity or charitable trust. The
donor can give away an asset worth $100 that cost
him $10 and get a deduction for $100, which can be
used to offset other income, possibly from capital
gains. A caveat, however, is that gifts of appreciated
property may subject the donor to the alternative
minimum tax. Also, the deduction for gifts of appreciated property is limited to 30 percent of adjusted
gross income on an annual basis.
Donors also can leave property outright to charity at death, which can amount to an unlimited estate
tax savings.
Split-Interest Charitable Trusts

Another option is a split-interest charitable trust.
Going back to the earlier scenario, Harry and Marie
Morgan are already concerned about the large tax
payment they will be forced to make as a result of the
sale of their first store, which had a nominal cost basis
and for which they received $1 million in cash and
securities. If they sell the balance of the business with
a cost of $100,000 and a market value of $1.5 million,
they will pay substantial capital gains tax immediately. Split-interest charitable trusts provide
both income and estate tax savings, while retaining
lifetime income benefits.
Two types of charitable split-interest trusts provide attractive alternatives in this situation: the charitable remainder trust and the charitable lead trust.
A charitable remainder trust is an irrevocable trust
that provides for a specified distribution at least
annually to one or more beneficiaries, one of which
is not a charity, for life or for a term of years not to
exceed 20, with the remainder interest to be held for
the benefit of, or paid over to, a qualified charity. In
a charitable lead trust, the income is paid to the
charity for at least 10 years, and the remainder returns to the individual or his heirs. The latter is most
appropriate for individuals with high current income who desire that the principal be preserved for
themselves or their families.
Two types of charitable remainder trusts will
pass muster with the IRS for estate tax deduction
purposes-an annuity trust and a unitrust. An annuity trust is a fixed annuity. If Harry and Marie
decide to put $500,000 into a charitable full remainder annuity trust, they would receive at least a 5
percent annuity on $500,000, or $25,000 a year income for their lives. Any growth in the trust would
pass for the benefit of the charity.
76
A unitrust provides for a variable annuity, so

each year, Harry and Marie would receive an annuity
of 5 percent or more based on the market value of the
trust assets. If they begin with $500,000 in the first
year at 5 percent, they would get $25,000. If the
principal grows the next year, they get 5 percent of
the higher figure. This gives them the opportunity
to keep pace with inflation, and their annuity will
grow with the trust assets. If the assets diminish in
value, however, so will their annuity.
Another distinction between an annuity trust
and a unitrust is that further additions cannot be
made to an annuity trust. If a unitrust is created for
the benefit of a select charity and the donor wants to
make an additional contribution, it permits such an
addition. Annuity trusts, on the other hand, are
more beneficial to the charity, which benefits from
the growth of the principal assets.
Assume Harry and Marie decided to put the
$500,000 in closely held stock into a charitable remainder trust, with the hospital as the charitable
beneficiary. To determine the size of the deduction
they would receive immediately, we need to know
the date of the gift, their ages, and the desired return,
which must be 5 percent or more. The lower the
percentage return, the higher the income tax deduction and vice versa. Assume they select 6 percent,
which will pay them a $30,000 annuity in the first
year. Using an actuarial table, this comes out to a
factor of 0.23993. Multiplying that factor times the
amount of the gift gives the charitable deduction in
the year of the gift as almost $120,000.
The basic income tax savings on a $120,000 charitable gift is more than $37,000. In addition, had this
$500,000 been in their estate when they died, they
would be paying some 50 percent in tax before the
asset passes on to their family. This gives them another $250,000 savings. Had they not considered this
option at all and sold the stock, they would have paid
$130,000 in capital gains, because this was a very
low-basis stock.
Using this technique, Harry and Marie accomplish many of their goals-maintaining a nice income from this $500,000 asset and getting an additional tax deduction in the year of the gift. They
generate total tax savings almost equal to the original
amount of the gift while meeting their concern about
helping the hospital. Also, this is a way of creating a
pool of funds for their investment advisor to manage
for many years.
The charitable remainder trust is most beneficial
for clients who are considering retirement; holding
substantial low-cost, low-yield securities; looking for
a way to increase their income and avoid paying big
capital gains taxes; possibly having some charitable
of which goes to benefit worthy charities.

interests; and having other assets that may be passing
to their families so they can afford to have some
assets pass to charity.
A charitable lead trust is the opposite of a chari- Conclusion
table remainder trust. In this case, the donor leaves
assets to a trust and provides an annuity for a charity
To summarize, we suggest to Harry and Marie that
for, say, 10 years. The charity would receive the
balancing the size of their estates is critical. The first
income from the trustfor a lO-year period. After that
issue is to make sure that if Marie dies first she can
period, the assets revert to either the donor or the
take full advantage of her $600,000 unified credit
donor's family. This is being used more and is poexemption. Second, we recommend they seek protentiallya larger benefit in an estate context than in
fessional counsel in preparation of new documents,
a lifetime context. If a client has substantial assets
either living trusts or new wills, that will take advanand is concerned with federal estate taxes, by putting
tage of all the aforementioned tax benefits. Third, we
a substantial amount of assets into a charitable lead
are concerned about Harry's $500,000 in life insurtrust and postponing the family's interest in any of
ance for two reasons. One, if he dies as the owner of
the income from that fund for years, at the end of that
the insurance, half the proceeds are subject to tax.
term, the assets revert to the family or pass on to
His other concern is, "How will our estates acquire
family members, the transfer of those assets can be
the cash needed to pay the taxes if we die and we still
virtually tax-free. This method makes very substanown this closely held company?" They should contial tax benefits available to the clients, provided they
sider setting up a new irrevocable trust for additional
are willing to give up a stream of income.
insurance, which would take effect at the death of the
survivor of Harry or Marie, known as "second-todie" insurance. This provides a tax-free fund of cash
Private Foundations
available either for taxes or for the family members
Setting up a private foundation is not quite as
tricky as the preceding tax-saving devices, and it has
at a reasonable cost during their lifetimes.
many built-in opportunities, both for tax savings and
They should also start a gift program using up to
$20,000 for each of their four children, four grandnontax benefits. A private foundation either can be
children, and potentially to inlaws. They also could
a corporation or a trust. The law requires that 5
add to their gift-giving program transfers by paying
percent of the market value of the foundation be
both tuition and health care costs of family members.
distributed to qualified charities each year.
The tax code was changed several years ago, so in
Of some concern is the excise tax of up to 2
addition to the $10,000 tax-free transfer to any indipercent on the income of a private foundation, alvidual, you may also pay an unlimited amount for
though in most cases, this is a nominal cost. The
primary advantage of the private foundation is that
tuition and health care, if paid directly to the instituthe individuals running the foundation have full
tion involved. This further reduces the estate of the
discretion in deciding which charities receive the
donor and passes money to the next generation withfunds. This discretion factor is what encourages
out any additional tax. In this case, Harry and Marie
many private individual clients to consider leaving a
have one child about to start college, another one on
substantial amount of money to a private foundaher way, and four grandchildren, which presents the
tion, because it will keep the family together to deopportunity to do some added estate tax planning
using tuition gifts.
cide how to give away the money and will continue
Finally, Harry and Marie should consider taking
the philanthropy of the family for years. A private
advantage of either a charitable remainder trust or a
foundation often is a perpetual entity, which means
private foundation to reduce the tax impact generan investment advisor will have a pool of funds to
ated by the sale of the closely held business.
continue to manage for many years.
From the investment advisor perspective, this
The only disadvantage of a private foundation is
plan creates several new pools of funds. First, the
that leaving money to the foundation does not preestate will be divided into two trusts, each of which
serve either an income interest or a remainder interest for the family. With that 50 percent potential
may run for a fairly long term. Second, the potential
gifts for children and grandchildren will need to be
estate tax liability hovering over the family funds,
managed. Third, the $300,000 pension benefit will
however, the foundation format may be difficult to
probably be rolled over into an IRA, and that, too,
refuse. It takes a little money from what would
will need investment counsel. Finally, there is the
otherwise have gone to the family and takes a lot of
charitable remainder trust or the foundation.
money from what otherwise would go to the IRS, all
77
Question and Answer session

William R. Levy
Question: Do you recommend
lifetime gifts with payment of gift
tax instead of paying estate taxes
at death?
Levy: If one makes gifts of
more than $600,000, the donor is
responsible for paying the tax on
any amount in excess of the
$600,000. If affordable, the payment of that gift tax can be beneficial because you have unloaded
additional assets from your taxable estate. If you know there
will be substantial appreciation, it
makes even more sense.
Question: What are your
thoughts on denouncing U.S. citizenship to eliminate estate tax for
high-net-worth individuals?
Levy: If the client is already living in another jurisdiction and has
no major concerns about giving
up U.S. citizenship, revoking citizenship can be advantageous, in
certain situations. A few years
ago, I had a situation with a Canadian resident who was a U.s. citizen. Canada has no transfer tax
upon death, but at the time of
death, it assesses a capital gains
tax on the unrealized appreciation of assets. So whether you sell
the assets or not, you will pay
capital gains tax. My Canadian
client was subject both to the Canadian capital gains tax and the
U.s. federal estate tax. Had she
given up her U.s. citizenship, she
could have avoided the federal estate tax.
Question: Are Canadian individuals holding U.S. assets at the time
of death entitled to the $600,000
credit exemption? Does estate/gift
tax apply to U.S. assets or foreign
assets of a resident alien?
78
Levy: If you are a foreign resident and citizen, you are only entitled to a $60,000 exemption, not
$600,000, on U.s. assets held in
your estate. If you are a resident
alien, all U.S. securities are subject to the federal estate tax.
Question: How does a company
manage the liability associated
with holding as trustee a life insurance policy from a company
that the donor may have selected
but that may not be strong financially?
Levy: This is a real concern.
We act as trustee of irrevocable
life insurance trusts. We are often
not consulted about whether we
approve the purchase of a particular policy. If we accept it, we
would have a potential liability
should the insurance company go
belly up. We are trying to do
more investigation before accommodating the insured in this context. Yet it is something to consider very carefully.
Question: Please enumerate the
charitable plans you mentioned
that may invoke the alternative
minimum tax.
Levy: The AMT is invoked
when an individual has tax preference items beyond a certain dollar amount. It requires a recalculation of the income tax after
throwing out most of the other deductions. Unfortunately, one of
those preference items is gifts of
appreciated securities to charity.
The threshold amounts permitted
in tax preference items for 1992
are $30,000 to start for an individual and $40,000 for a couple.
These figures increase with the
amount of income. This means if
a married couple transfers appreciated assets and the appreciation

is less than $40,000, they are safe
from AMT, provided they have
no other tax preference items
such as special-purpose municipal bonds or items related to passive real estate losses. Any large
charitable gift of appreciated securities becomes a tax preference
item, and this could subject somebody to AMT whether the gift of
appreciated securities goes to a
foundation, directly to a charity,
or to a split-interest charitable
trust.
Question: What is the position

of the IRS if an annuity or unitrust is funded solely with tax-exempt investments to generate taxexempt income to the beneficiary?
Levy: The problem in doing
that is not the IRS. The real problem is that whoever is acting as
trustee is responsible not only to
the individual receiving the income but also to the ultimate beneficiary. In a trust holding exclusively municipal bonds with very
little appreciation, the trustee
could be subject to a surcharge action by the charity for not considering its needs. Also, once the
portfolio is structured, even
though a substantial part of it is
invested in tax-exempt securities,
the income from the nontax-exempt securities is deemed to have
been distributed first, the tax-exempt portion cannot be allocated.
The beneficiary is deemed to
have received the income on the
taxable securities before the taxexempt income is allocated.
Question: Is there a way to
equalize estates for clients with
$1.2 million in net worth, of
which $1 million is in an IRA in

the husband's name?
Levy: There is one way, but it is

not a very good one. Once a client reaches age 59 112, he is permitted to withdraw all of his IRA
without any penalty. Before 591;2
years of age, he will pay a penalty, and he will always pay income tax on the amount drawn
out of his IRA. With the highest
income tax at 31 percent and the
highest federal estate tax at 55
percent, in some situations,
equalizing the estates would be
beneficial.
Question: For an irrevocable
life insurance trust, what part
does the age of the donor play in
the value of this strategy?
Levy: If someone dies quickly,

the irrevocable insurance trust is
a great scheme. If the person
lives many years, however, those
premiums build up and the benefit is reduced. Many of the policies used in this context are second-to-die and are also vanishing
premiums. Insurance companies
have not been doing well, and
what was going to be a 7-year
vanishing premium now is 9 and
on its way to 10 years. Given the
amount of money people pay
over a lifetime to the insurance
company in an irrevocable life insurance arrangement, if the clients live a substantial number of
years, they might have done
much better investing the money
held in an irrevocable trust (even
after income tax), especially if
they have a large group of potential gift donees.
Question: Can Harry and Marie
donate their stores to the charitable trust and shelter the gain on
the sale?
Levy: They can, as long as the

sale is an arm's length transac-
tion. They have closely held

stock, and a bona fide offer for
that stock supports the value for
charitable deduction purposes.
They convey a third of the stock
in the closely held corporation to
the charitable remainder trust,
and the trustee of the trust sells it
to the company who is buying
the firm. The cash is paid to the
corpus of the charitable remainder trust. The IRS is not going to
fight the fact that this was a charitable deduction unless they can
show a scheme involved in placing the value artificially high to
get a larger charitable deduction.
nership as the vehicle for transferring wealth, you have the problem of valuing a $10,000 gift of an
interest in a limited partnership.
If you file gift tax returns and
time passes and the IRS has not
come back and questioned it, you
still have the problem at death.
The IRS can come back and say,
"The interest in a limited partnership that you valued at $10,000
was a legitimate gift, but we
think it was worth $30,000."
Thus, the IRS can tax the difference after you die.
Question: Are there any problems with the situation in which

an investment manager, who is
also a friend, is named as individual trustee?
Question: Can an appreciated

asset be given to GRITs, GRUTs,
and GRATs; sold to avoid capital
gains taxes; and then reinvested
in a higher-yielding investment,
the same as when charitable
trusts are used?
Levy: The situation is a little

clearer with an investment manager than an attorney who draws
the document. An attorney who
names himself as fiduciary has a
problem in the sense that the
code of professional responsibility suggests this is inappropriate
unless the parties are related. At
least we know when an investment counselor has been named
in a document drawn by an attorney that an opportunity to discuss the decision has occurred.
Levy: GRITs, GRUTs, and

GRATs are split-interest trusts
similar to a charitable remainder
trust in that the income beneficiary is different from the principal beneficiary. No charitable deduction is associated with a GRIT,
GROT, or GRAT, however. They
provide ways of enhancing or leveraging a $600,000 annual exclusion during a person's lifetime.
They differ from a charitable remainder trust in that the donor
does not avoid capital gains tax.
Question: Do you use family

limited partnerships? If so, how?
If not, why?
Question: Please discuss the tax

treatment on the income distributed from the unitrust to Harry
and Marie.
Levy: The use of family limited

partnerships is a question of valuation. The only benefit of putting
assets in a family limited partnership would be that making the
transfer each year in units to the
partnership may simplify things
in that you have a regular routine
of transferring interest in the partnership to various family members. The problem is the valuation. If you use that family part-
Levy: If the charitable unitrust

is invested exclusively in taxable
securities, the income beneficiaries will pay income tax each year
on the income they receive. When
the income is partially tax exempt
and partially taxable, then all the
taxable income is taxed first.
Question: What are the pros
and cons of a married couple
79
owning their primary residence

jointly?
trust assets to an unnecessary estate tax at the death of the holder.
Levy: Most couples prefer holding their primary residence jointly

for several good reasons, including protection from claims of
creditors of either spouse, ease of
administration upon the death of
either spouse, and avoidance of
federal and most state death taxes.
Question: For individuals with

estates of $5 million or more with
high liquidity, when would you
use GRITs, GRUTs, and GRATs
instead of an established irrevocable trust and funding with a
$600,000 estate tax exemption
equity?
Question: Does the power of appointment apply to a family trust

as well as a marital trust?
Levy: The primary benefit of a

split-interest noncharitable trust
is to leverage the $600,000 lifetime gift tax exemption. The
other advantage is that it provides for an income interest for
the donor, which is not available
with an irrevocable trust.
Levy: Yes. It is critical, however, that only a limited or special

power be used in a family trust.
A general power will subject the
80
Question: Instead of using an irrevocable life insurance trust,

why not simply make cash gifts
to adult children, who can then
purchase life insurance on their
parents'lives? Doesn't this accomplish the same goals without
the extra details?
Levy: Although making gifts directly to children is much easier
and accomplishes the same tax
benefits, the problem is that the
donor loses an element of control.
He no longer can ensure that the
gift money is used to pay insurance premiums or that the proceeds will be available if the estate has liquidity needs.
Portfolio Management for Private

A Case Study
Mary Jo Vaughn-Rauscher Professor of Financial Investments
Southern Methodist University
This case study illustrates the process of managing private client investments, a task that
requires tailoring actions to the unique and changing objectives of each client.
Private clients cannot be lumped together as a single

homogeneous group. Each client is unique and has
different goals, preferences, and needs. Investment
counselors must address each client-specific consideration before advancing to the stage of making portfolio recommendations.
In this presentation, I will discuss the Ramez
family cases. The cases and the introductory material that follows were taken from the textbook Cases
in Portfolio Management. 1 The guideline answers suggest appropriate, but not necessarily exclusive, solutions to the cases. To hone your applied portfolio
management skills, you may want to tackle the additional cases presented in the casebook.
The case study approach is designed to provide
practical examples of the techniques, concepts, and
theories used to solve a problem. To solve a case, you
must combine your skills with your judgment and
creativity. A case study is an unusual learning tool
because no particular answer is the only and irrefutable one. Instead, you apply your knowledge and
experience to a specific situation and, in this case,
determine an appropriate investment policy and
asset allocation.
The portfolio management process consists of an
integrated, consistent set of steps by which an investment counselor creates and maintains appropriate
combinations of investment assets. As depicted in
Figure 1, it is a dynamic and flexible process, complete with feedback loops, monitoring, and adjustments. The mechanics of the process may vary from
manager to manager, but the process itself is comlJohn W. Peavy III, CFA, and Katrina F. Sherrerd, CFA, Cases
in Portfolio Management (Charlottesville, Va.: Association for
Investment Management and Research, 1990).
mon to managers everywhere. 2 Accordingly, your

deliberations on the Ramez cases should.include the
following steps:
Identify the problem. Determine what actions
are necessary to respond properly to the situation
presented.
Prepare an investment policy statement. The
statement must accurately specify the investor's objectives, constraints, and preferences.
Recommend an asset allocation. The allocation
must reflect the investment policy and relevant economic, political, and financial market considerations.
Monitor inputs. Framework for monitoring
investor-related, economic, and market input factors
must allow the portfolio to adjust as these inputs
change.
The portfolio management process can be effectively applied to the management of private client
investments, which must be tailored to the unique
needs and objectives of each individual. Each client
has a different liquidity need, time horizon, and set
of constraints. Many clients have a combination of
taxable and nontaxable portfolios, and many do not
have a full grasp of their own risk tolerance or the
risk characteristics of the assets available to them.
Psychological characteristics also play an important
role in managing investments for private clients.
A carefully planned investment policy for an
individual investor must incorporate all of the individual factors pertaining to that investor. Investment objectives must be defined in terms of return
requirements and risk tolerance. Constraints, such
2A more detailed description of the portfolio management
process can be found in John L. Maginn, CFA, and Donald L.
Tuttle, CFA, Managing [nuestment Portfolios,
2d ed.
(Charlottesville, Va.: Association for Investment Management
and Research, 1990).
81
Figure 1. The Portfolio Construction, Monitoring, and Revision Process

and
uantification of
Investor Objectives,
Constraints, and
Preferences
---..
Portfolio
Policies and
Strategies
r--
Monitoring
Investor-Related
Input Factors
Portfolio Construction
and Revision
Asset Allocation,
Portfolio 0timization,
Security Iection,
Implementation,
and Execution
Capital Market
Expectations
I--
Relevant Economic,
Social, Political,
Sector, and Security
Considerations
Attainment of
Investor Objectives
Performance
Measurement
I
Monitoring
Economic and Market
Input Factors
Source: John L. Maginn, CFA, and Donald L. Tuttle, CFA, Managing Investment Portfolios, 2d ed. (Charlottesville, Va.: Association for
Investment Management and Research, 1990).
as liquidity, time horizon, and tax, legal, or regulatory considerations, must be recognized explicitly
and taken into consideration in formulating the investment policy for each client. Preferences also
must be identified and respected.
The investment policy for each client is embodied in an operational statement that sets forth guidelines specifying the actions necessary to achieve the
client's objectives within the constraints imposed
and the preferences expressed. Many portfolio investment considerations are qualitative, but all lead
to quantification of return and risk requirements that
can be translated into an efficient, individually tailored portfolio.
The Ramez Family-Case A

Martina Lindell, CFA, is reviewing the file of the
Ramez family, her first non-U.s. client. This client is
especially important to her firm, Dexter Associates,
because it is beginning to expand its services internationally. Lindell is to provide recommendations on
asset allocation for the Ramez portfolio and on
whether the firm should engage an outside manager
for the international equities to be included.
Dexter Associates
Dexter's management is "top-down." The firm
begins with broadly defined economic scenarios and
82
proceeds in a systematic, disciplined manner to asset

allocation and security selection. For many years,
the firm has included only domestic stocks and
bonds in its portfolios. This year, however, it has
decided to broaden the asset classes available for
client portfolios by adding equity real estate, international equities, and precious metals. The firm has
proceeded cautiously in this change and has not yet
brought into the firm all the personnel required to
manage the three new asset classes.
Dexter Associates prides itself on its economic
forecasts. Table 1 contains its current three- to fiveyear forecasts of expected annual total return, yield,
and standard deviation under three possible economic scenarios. The firm believes that the most
likely scenario is one of low growth and low inflation.
The Ramez Family

Luis and Inez Ramez have recently sold their
family business for $10 million and immigrated to
the United States from the Philippines. They have
been accepted for residence and intend to become
U.S. citizens. Mr. Ramez intends to use a portion of
the proceeds from the sale of his business to fund a
new business venture. Mrs. Ramez expects to pursue charitable activities benefitting needy Philippine
families throughout the world.
The Ramezes have three children: Pedro, 19,
Table 1. Dexter Associates' Capital Market Outlook,

Three- to Five-Year Projections
Expected
Annual Total
Return
Low growth, low inflation

(60% probability)
Cash equivalents
Domestic bonds
Domestic stocks
Equity real estate
Precious metals
Rapid growth, high inflation
(20% probability)
Cash equivalents
Domestic bonds
Domestic stocks
Equity real estate
Precious metals
Depression/deflation
(20% probability)
Cash equivalents
Domestic bonds
Domestic stocks
Equity real estate
Precious metals
Expected
Annual
Yield
Expected
Annual
Standard
Deviation
capital losses twice-once as the result of rapid inflation and once as the result of depression. He does
not want to have to rebuild the family's asset base a
third time. He also wants to retain the ability to raise
large amounts of cash quickly and to hold 5 percent
of his portfolio in precious metals.
The Task
5%
11
15
11
8
0
10
-12
8
16
14
20
5%
8
3
2
3%
15
22
25
2
12
10
12
4
3
3
17
20
22
7
15
Lindell reviews her notes before preparing her

recommendations on an investment policy and asset
allocation for the Ramez portfolio. She is confident
that some level of international exposure would be
appropriate for the Ramez portfolio, so she also plans
to present an analysis of possible international equity
managers.
Because this is her first international client,
Lindell wants to do the best job possible. She plans
to start with the investment policy statement and
then move into asset allocation and the question of
international managers.
Guideline Answer-ease A
2
15
-12
-14
0
5
2
6
1
1.5
o
o
3
13
24
27
7
12
This case introduces several aspects of international

investing for individuals by bringing international
equities, real estate, and precious metals into the
allocation equation.
Investment Policy Statement

currently a student in Paris, intends to practice medicine in his native Philippines; Marco, 23, lives with
his wife in Singapore, where they have recently
begun an international import/export company; and
Maria, 25, who is currently enrolled in a masters
program in political science, lives in Panama with her
husband, a banker, and their two children. Although
the Ramezes have carefully raised their children to
be self-reliant and self-supporting, they intend to pay
for their children's and grandchildren's education
and occasionally to provide for special needs the
children encounter. The children are not aware of
the extent of the family wealth.
The proceeds of the sale of the Philippines business were placed in U.s. cash equivalents and prime
non-U.s. certificates of deposit. Mr. Ramez estimates
that the family's annual income needs should be
about $400,000 after taxes; he understands that he
and Mrs. Ramez will pay U.S. taxes as if they were
already U.S. citizens.
Mr. Ramez has told Lindell that he had been
attracted to Dexter Associates because of its reputation for economic forecasting. He is particularly concerned about protecting the family's purchasing
power. In the Philippines, he had suffered severe
The investment policy should reflect the return

and risk objectives of the Ramez family, as well as all
relevant constraints on achieving those objectives.
The objectives are as follows:
Return requirements. The two return objectives are to provide for family income needs of
$400,000 a year after taxes (roughly a 4 percent net
yield requirement) and to maintain the purchasing
power of the Ramez family wealth over time.
Risk tolerance. The Ramez family's biggest
concern is protecting the portfolio from the ravages
of extreme economic environments such as deflation/ depression and rampant inflation. Therefore,
Lindell should try to structure the portfolio to
achieve above-average total portfolio flexibility and
adequate liquidity. This goal can be accomplished
with moderate risk taking accompanied by diversification across a broad array of assets.
The relevant constraints on achieving the objectives are as follows:
Time horizon. The time horizon should be
viewed in two stages. The first might be two or three
years, during which Mr. Ramez may require capital
to start another business. In the second stage, the
time horizon is longer, with the Ramez family investing for their own needs, for future generations, and
83
possibly for charities in the Philippines.

Liquidity. Mr. Ramez's desire to be able to
raise cash on short notice implies more-than-normal
liquidity and special attention to asset marketability.
Over time, a sizable amount of liquidity could be
needed to meet the demands of 0) Mr. Ramez's
renewed interest in business, (2) problems the children might encounter, and (3) special charitable contributions.
Laws and regulations. No special legal or regulatory problems seem to exist, although transferring funds to the children might pose some technical
and tax problems.
Taxes. Mr. Ramez is subject to the same taxes
as U.S. citizens. He has not asked Dexter for tax
advice.
Unique preferences and circumstances. The
Ramez family is scattered throughout the world. If
the Ramez parents plan to send their children money
overseas, then some international exposure in the
portfolio might be advisable to hedge against exchange rate fluctuations. Mr. Ramez has experienced the ravages of both inflation and depression in
his native Philippines and has expressed a desire that
the portfolio maintain its purchasing power in the
worst of economic times. Hence, the portfolio
should be broadly diversified, with some assets that
do well in an inflationary environment and some that
do well in a deflationary environment. He also has
requested a 5 percent allocation to precious metals.
Asset Allocation
An asset allocation that emphasizes equities
accomplishes the Ramez's investment objectives
fairly well. The portfolio should have between 50
and 70 percent in equities, between 15 and 25 percent
in bonds, 5 or 10 percent in Treasury bills, 5 or 10
percent in real estate, and 5 percent in precious metals. Quality and marketability should be emphasized on all assets.
The expected high income yield and the unusually low incremental expected total return of stocks
versus bonds suggests that a higher-than-average
allocation to bonds is warranted. Furthermore, the

bonds are the best-performing asset class in the deflation scenario.
One portfolio that meets the policy is: domestic
stocks (40 percent), international stocks (20 percent),
bonds (25 percent), cash equivalents (5 percent), real
estate (5 percent), and-as requested-precious metals (5 percent). This allocation provides adequate
liquidity, meets the stated income objective, and
most importantly, provides broad diversification.
Based on the recommended allocation, the portfolio produces the results shown in Table 2. The
portfolio hedges the inflation and deflation scenarios
reasonably well. Liquidity is maintained, a reasonable level of international exposure exists, and the
downside protection is reasonably good.
Table 2. Ramez Family Investment Results

Scenario
Total
Annual Return
Aftertax Annual
Return
11.6%
5.6
-3.5
7.4
4.2%
6.0
2.3
4.2
Low inflation
Inflation
Deflation
Expected value
Manager selection
Table 3 shows results for three international
portfolio managers with different styles and performance records. None of the managers outperformed
the Europe/Australia/Far East (EAFE) Index, although all of them outperformed the S&P 500. Their
volatility and the proportion of currency exposure
differ.
Manager A has the lowest average return (20.4
percent) and the lowest volatility, measured by standard deviation. Manager A's performance is highly
correlated with the performance of the S&P 500,
although this may be merely coincidental, because
Manager A has a large average currency exposure.
Manager B has the highest average return (28.2
percent) and the highest volatility of the three man-
Table 3. Dexter Associates' Manager Performance Data

Annual Rates of Return
Manager A
ManagerB
ManagerC
EAFEIndex
S&P 500 Index
84
Year 1
Year 2
Year 3
Year 4
YearS
17%
-12
5
-1
22
24%
26
28
25
23
5%
10
12
7
6
34%
55
50
56
32
22%
62
45
68
18
Average Currency
Component of
Return
60%
20
40
20
0
agers. Manager B's performance is highly correlated

with that of the EAFE Index but is higher in volatility.
Manager C has the second highest average return (28 percent), although this performance is insignificantly different from the performance of Manager B. Manager C had significantly lower volatility
than Manager B, however. Manager C relied more
heavily on currency swings favoring the dollar than
did Manager B.
Selection of managers is largely a subjective exercise, with "chemistry" playing an important role.
The information provided is insufficient to document the quantitative superiority of any of these
managers relative to the others. Therefore, Lindell
will have to determine which manager best matches
the Ramezes' attitudes toward investment management. Other factors being equal, Lindell should seek
competence in managing in non-U.S. markets. Comparisons to S&P performance are not really germane
here.
The Ramez Family-Case 8

It is now three years later. Shortly after her annual
meeting with the Ramez family, Lindell found herself preparin.g for yet another meeting. Mr. Ramez
has decided to join a privately held international
investment group specializing in global mineral extraction. He now is contemplating investing $5 million for a royalty interest in an Australian oil field.
He expects that his return on this investment will
approximate $1.5 million a year, and petroleum engineers have projected a lO-year productive life
based upon current technology. The field's production will be sold under contract to a major international oil refiner.
Lindell is concerned about how well this investment fits into the investment policy developed initially for the Ramezes. A commitment this large-42
percent of the now $12 million portfolio-violates
proper diversification rules. Furthermore, she has
no information on the riskiness of the royalty payments. If they materialize, they will provide far more
income than needed to meet the Ramez family's
current requirement of $425,000 a year.
Regardless of Lindell's opinion on the matter,
she knows she must prepare for the possibility that
Mr. Ramez will withdraw $5 million from the existing portfolio by developing a plan to accommodate
that eventuality. In preparation for a meeting with
Mr. Ramez, Lindell identifies two issues she must
resolve:
1. Can the existing investment policy accommodate such an investment? If not, how should the
policy be modified?
2. What, if any, asset allocation revision would

she recommend if Mr. Ramez makes the investment
and if the expected royalty level materializes?
Guideline Answer-Case 8
This case provides an opportunity to revise an investment policy and asset allocation in a situation in
which nearly half of the portfolio assets are being
withdrawn from the portfolio and invested in a hardto-value investment alternative.
Investment Policy Statement

To reflect recent developments, the Ramez investment policy must be revised. The revised objectives are as follows:
Return requirements. The investment goal
shifts from the production of income to appreciation
in the Dexter-managed residual portfolio. The royalty income (if it materializes in the amount anticipated) should be sufficient, even after taxes, to meet
the $425,000 annual income requirement and to return the investment in 10 years.
Risk tolerance. The Ramez family's tolerance
of risk (volatility) has increased, because one important call on liquidity has been met. The royalty presents a significant business risk, however, and the
balance of the portfolio should avoid duplicating
that specific risk.
The revised constraints are:
Time horizon. This remains a two-level consideration, but with different dimensions than before. The first horizon is now 1 to 10 years, and the
second from 25 years (the Ramezes' life expectancy)
to infinity (future generations).
Liquidity. The large cash flow reduces liquidity needs, but the illiquidity of the new investment suggests that other assets should remain marketable in case conversion of a further portion of the
portfolio to cash is required.
Laws and regulations. No changes.
Taxes. Taxes remain an important consideration; in particular, the effect of taxes on royalty income must be determined and minimized if possible.
Unique preferences and circumstances. The reinvestment problem of the royalty cash flow must be
addressed. Also, the existence of this sizable asset in
its unique form will alter commitments in other components of the portfolio.
Portfolio Restructuring
The portfolio should be restructured so that income is completely deemphasized in favor of
growth. The royalty is equivalent to an annuity
(fixed-income asset substitute) with a specified life.
85
The cash flow, after meeting income needs, must be

invested so as to recoup the inflation-adjusted principal in 10 years. Because the investment is so large
and involves a natural resource, precious metals
should be eliminated from the portfolio, as should
any energy or other raw materials stocks. Close
attention should be paid to potential dividend
growth so that income production in the tenth year
and beyond will meet the stated requirements.
The royalty's fixed-income qualities eliminate
the need for domestic and international bonds in the
portfolio. The royalty's commodity base contributes
inflation protection, making real estate an unnecessary, although still acceptable, asset; the illiquidity of
physical real estate argues against that form, however.
The revised portfolio should be invested in equities, with a small (less than 5 percent) cash position
86
for liquidity. Within equities, between 60 and 70

percent should be invested in domestic equities, with
the balance in international equities. This portfolio
meets the growth-orientation objective. The royalty
income and dividend income meet the income objective.
The royalty investment will generate more cash
than the Ramez family needs in a year. This extra
cash flow, some of which is really a return of principal, must be reinvested. Assuming a 2 percent dividend yield on the stocks, the Ramez portfolio will
generate an estimated $140,000 a year in income, or
33 percent of the family's income requirement. The
royalty will provide the additional $285,000 a year.
Thus, the royalty income in excess of $285,000 should
be reinvested. An argument could be made for investing the excess in long-term bonds to replace the
royalty as it declines and to diversify the portfolio.
Applying the AIMR Performance Presentation

Standards to Private Clients
President
CSI Asset Management, Inc.
In presenting performance numbers to private clients, investment firms should comply

with the AIMR Performance Presentation Standards, which emphasize full disclosure
and fair representation.
The development of the Association for Investment

practice. The committee also has several subcommitManagement and Research (AIMR) Performance
tees working on areas that might cause special problems in adopting the standards, including leverage,
Presentation Standards is the first major initiative
bank trusts, and real estate and international investaimed at achieving consistency and full disclosure in
ments.
the way investment managers report their results to
clients and prospective clients. This effort began in
1986 with the formation of the Committee for Perfor- - - - - - - - - - - - - - - - - - - - - mance Presentation Standards, chaired by Claude Problems in Perfonnance Reporting
Rosenberg, within the Financial Analysts Federation
The motivation behind the standards was to over(FAF). The committee's report, now known as Percome some observed problems in performance reformance Presentation Standards, was published in the
porting. For exainple, Table 1 presents three entries
September/October 1987 issue of the Financial Anafrom Nelson's 1991 Directory of Investment Managers
lysts Journal. During the next year, the committee
that are indicative of the current state of industry
received and evaluated comments from investment
reporting. Manager A manages $4.8 billion in an
practitioners. This feedback was used to revise and
unknown number of portfolios but only shows the
refine the initial standards.
performance of one balanced account. The manager
After AIMR was formed in 1990 by the joining of
does not show separately the performance of equity
the FAF with the Institute of Chartered Financial
or fixed-income accounts. Manager B manages 433
Analysts, the AIMR Board of Governors endorsed
portfolios valued at $1.5 billion and chooses to show
the standards, formed an Implementation Committhe performance of only one large balanced account
tee, and set up a schedule for implementation of the
and one large equity account. Finally, in the spirit of
standards by AIMR members. This schedule called
honesty, Manager C discloses that he is showing the
for publication of an Implementation Committee reperformance of his best equity and fixed-income
port by the end of 1991, adoption of the standards by
portfolios. Manager C does not, however, disclose
members in 1992, and incorporation of the standards
how many accounts he has, nor whether the best
into the AIMR Code of Ethics and Standards of Properformance is representative of the average perforfessional Conduct by January I, 1993.
mance.
The Implementation Committee, originally
We all recognize that this information is not
chaired by Frederick L. Muller, CFA, and now coacceptable. To help the industry deal with this probchaired by R. Charles Tschampion, CFA, and Lee N.
lem, the Securities and Exchange Commission (SEC)
Price, CFA, was assembled from a cross-section of the
has demanded certain disclosures of investment
industry-investment managers, bank trust compamanagers, but these disclosures are generally fonies, plan sponsors, and consultants. This committee
cused on warning the reviewer not to read too much
has spent considerable time developing guidelines
into the numbers. Although that is helpful in many
for members to use in putting the standards into
ways, it does not ensure completeness and fairness
87
Table 1. Perfonnance Reporting without Standards

Item
Money Manager A
Money Manager B
Money Manager C
Assets under management

Number of accounts
Balanced account
performance
$4.8 billion
N/A
One representative
account
N/A
$1.5 billion
433
One large
representative account
One large
representative account
N/A
$400 million
N/A
N/A
Equi7c account
per ormance
Fixed-income account
performance
N/A
Top fund
Top fund
Source: Nelson's 1991 Directory of Investment Managers.

Note: N / A = not applicable.
in the presentation of the information shown.

The AIMR standards are intended to improve
the completeness and uniformity of the performance
information managers provide their clients and potential clients. The way investment results are calculated and presented is crucial to permit comparison
among managers and reduce the potential for gaming the presentation. Guidelines that standardize the
process are a major step toward fair representation
of results. They also will reduce the need for additional government regulation to accomplish the
same end.
The primary goal of AIMR's standards is to enhance the utility as well as the credibility of performance presentations. Many people argue that historical results do not have much value because they
do not guarantee similar performance in the future.
Nevertheless, investors demand historical performance results before choosing or retaining their
managers, and managers therefore supply such results. If such a representation occurs, it should be fair
and include full disclosure of what those numbers
contain.
It is also important to note that the emphasis of
the standards is performance presentation, not performance measurement. Some specific guidelines
and rules should be followed, but much flexibility
exists in the calculation of results; there is less flexibility, however, in the way the numbers are presented.
Composites
Performance composites are the key focus of the
standards. A composite is simply the aggregation of
the performance of a number of portfolios into a
single number that is representative of a particular
strategy. Composites promote consistency because
they comprise all portfolios managed according to a
specific investment style or strategy rather than "rep88
resentative" accounts that may in fact bear little resemblance to other portfolios and fail to reflect the
firm's ability. The performance of representative accounts may provide valuable information to consultants and prospective clients-and it is acceptable to
show it as supplemental information-but it is not
sufficient to provide a basis for sound judgments
about firm performance.
The guidelines require that, in building different
composites, a manager aggregate portfolios into
groups that share such attributes as style of management, degree of manager control over that style, the
kinds of assets in the portfolios, and the risk considerations in that approach. These guidelines apply to
all fully discretionary accounts-those for which the
investment manager has control over the investment
decisions-and all fee-paying accounts. If nondiscretionary accounts are shown, they must not be
combined in the same composite with discretionary
accounts.
No universal definition of discretion exists. It is
situational and often depends on the investment
management approach being applied. Therefore,
managers themselves must define "discretionary" in
the light of their specific situations. Take, for example, a situation in which contractual, or legal, discretion exists, but a turnover constraint hinders the
manager's ability to make portfolio decisions. The
return expected on this portfolio would likely be
different from other portfolios being managed using
the same strategy but without the turnover constraint. In this case, the manager does not have investment discretion and should not include this portfolio in the composite for the strategy.
The results for a composite must include the cash
allocated to each asset class; that is, no stock-only or
bond-only numbers can be used as representation of
a composite return.
Calculations
In presenting results, individual annual period

returns must be shown for the history of the composite, although each annual return must be shown to
meet the standards. Showing cumulative growth
over a period of time is also acceptable as additional
information.
To create comparable data, the treatment of accounts

within composites must be consistent. The standards provide minimum calculation requirements
and recommended guidelines.
Performance must be calculated using a timeweighted rate of return formula, and the rate shown
must be the total return-the capital or principal Tax Considerations
change plus attributable income. For fixed-income
Private client accounts pose several additional consecurities, accrued interest must be shown to attrisiderations. The standards are not difficult to apply
bute performance to the time period in which it was
to taxable accounts, but fair representation and full
actually earned by the account or portfolio. Results
disclosure may require going beyond the minimum
before fees are preferred but not required. If after-fee
requirements of the standards in these situations.
returns are shown, as they may be in certain situaOne issue is discretion. Tax considerations, for extions to meet the SEC guidelines for net-of-fee calcuample, may create hurdles that hinder the return
lations, sufficient fee information must be disclosed
potential of a particular strategy. The private client
to allow the calculation of a gross-of-fee number.
industry will have to determine what it considers
AIMR strongly recommends showing results before
appropriate, acceptable, and fair representation of
fees with the fee schedule included.
performance numbers under these conditions. We
The standards encourage monthly or even daily
hope such guidelines will emerge as the industry
valuation to promote more accurate return calculaevolves and as the technology improves.
tions and to avoid problems with intraperiod cash
The first issue to be resolved is pretax return
flows. The most accurate method for calculating
disaggregation-that is, breaking down the return of
performance is to conduct daily valuations, but for
a taxable account into principal return, dividend inmost firms at this time, daily valuation is too expencome, taxable interest, and tax-exempt interest. Prisive or impractical. If a firm cannot calculate these
vate clients often participate in partnerships or mudata daily, it should do so monthly, and approximate
tual funds that provide this information on K-ls.
the effect of the cash flows. If monthly valuation is
Investment managers must recognize that this infornot possible, then it should be done at least quarterly,
mation will be demanded together with sufficient
again approximating the effect of the cash flows to
explanation of the meaning of the numbers.
avoid as much distortion as possible. The perforAlthough pretax returns are important, the components of pretax returns are more important than
mance periods then must be geometrically linked.
Within a composite, the portfolios must be
the overall pretax return, because the actual investment returns of the client will be realized on an
weighted by account size; equal-weighted composaftertax basis. Thus, calculating an aftertax return
ites are encouraged as supplemental information.
may make sense, but any assumptions should be
Both AIMR performance presentation committees
disclosed,
and the methodology should be exspent much time discussing the pros and cons of
plained.
Possibly,
turnover or expected holding pepresenting size-weighted versus equal-weighted
riod
statistics
should
also be provided, although
composites. Each is an average return number, and
turnover
data
do
not
in
themselves explain the tax
each provides biased results. The Implementation
implications.
If
people
understand
expected turnCommittee strongly recommends that both equalover
or
the
expected
holding
period
statistics of a
and size-weighted composites be shown for comparstrategy,
they
can
gain
some
idea
of
what
should be
ison purposes, but the size-weighted composite is a
expected
for
aftertax
returns
over
the
long
run,
given
minimum requirement.
the
parameters
of
the
strategy
being
used.
Most people agree that size-weighted composites are harder to game. With an equal-weighted
composite, a manager could put successful trades in
Rules Governing Composites
small accounts, thereby inflating the small-account
return, which would then be used to inflate the comHow many composites should a manager create? In
posite. This strategy is not possible in a sizesome cases, creating only one composite will be alweighted composite. For firms with consistent permost impossible. All discretionary, fee-generating
formance across portfolios, this weighting distincaccounts must be in at least one composite, but multion is not an issue, because both calculations will
tiple composites are encouraged as determined by
investment objectives, risk parameters, and the ingenerate similar results.
89
vestment managers themselves. The composites

shown to each client should be applicable to that
client's circumstances-for example, a large-account
composite should not be shown to a very small client
if small accounts are in a different composite. All of
those clients might be put in one composite that
would be applicable. At the same time, however, a
list of composites must be made available to all prospective clients at their request.
The standards enumerate requirements for
maintaining composites. All accounts should be included in all of the periods that they meet the composite criteria, and they should not be included for
the periods in which they do not meet the composite
criteria. Also, historical results of lost accounts must
be included to prevent survivor bias within the composites.
The composites should represent the performance of the firm, not that of a particular portfolio
manager. Therefore, a composite should not be altered when a portfolio manager departs. A more
common problem that arises in the industry is the
handling of a portfolio manager's results before he
or she joined the firm. The standards are clear in this
area. Prior results can be shown as supplemental
information to the composite but cannot be linked
with conforming composite results. Simulated or
model performance must also be excluded; no paper
portfolios are allowed. In a size-weighted environment, a simulated portfolio falls out anyway because
it has no assets associated with it, and thus it will
have no weighting. Assets of pilot accounts, which
have assets involved but no fees, should also be
excluded. Disclosure is required in the rare case that
such accounts are included in a composite.
Disclosure is an important part of the standards.
During the past 5 or 10 years, the number of disclosures in investment presentations has ballooned,
but-based on the SEC's requirements-the information often details what is not in the composite
rather than what is in the composite. That is a reasonable first step, but more information is needed to
make informed decisions.
The standards require that certain disclosures be
deemed supplemental information provided with a
composite, as opposed to separate from the composite. For example, a portfolio manager's prior results,
simulated or pilot results, asset-only results, equalweighted composites, and other similar information
should be presented with the current results rather
than mixed in with the firm's current results. This
information is valuable and provides important insights into the performance numbers. Using this
information means changing the way we all view
disclosures. The handling of balanced accounts90
that is, accounts with more than one asset class-in

the standards has caused some confusion. The treatment of these portfolios is really quite simple, however. Total account performance is the most important piece of information in calculating and presenting return numbers on balanced accounts, and showing this total account performance number is the
only mandated requirement with regard to balanced
account returns. It includes cash and all securities.
If a manager wants to show expertise in one specific
asset class within a balanced account, the cash in the
account must be properly allocated to that asset class.
If asset-only numbers for a balanced account are
valuable supplemental information that a prospective client might want to see, the asset-only numbers
may be shown, but these numbers cannot be shown
as a stand-alone composite. Instead, they may be
shown as supplemental information to the balanced
composite.
Several disclosures relating to composites are
required, including:
Statistical information. Presentations must
include statistical information about each composite,
including the number of portfolios in the composite,
the total asset amount in the composite, the
composite's percentage of the firm's total assets
under management, and an explanation of how the
balanced results are handled.
Subcomponent information. If the subcomponents of a balanced account are included in an
asset-only composite-that is, if the equity component of a balanced account is included as part of an
equity composite-the composite of the stand-alone
asset class must contain a disclosure that it includes
the appropriate subcomponent ofa balanced account
and an explanation of how the cash was allocated to
that subcomponent.
Return calculation information. The composite should be accompanied by an explanation of how
returns are calculated-gross or net of fees-as well
as a fee schedule. AIMR considers gross of fees
preferable in showing performance results.
Leverage information. Whether and to what
extent leverage is being used in an account are also
required disclosures, although several issues with
regard to leverage are still under consideration by a
subcommittee of the Implementation Committee.
Results of the subcommittee's work will be published and incorporated into the standards.
Accounting information. Disclosure is also required of the use of settlement date or trade date
accounting. Trade date accounting is preferred, but
many managers use custodial statements that are on
a settlement account basis, which cannot be re-created on a trade date accounting basis. If settlement
date accounting is used, it should be disclosed.
Verification
Some people would like to have mandatory verification of presentation data and methods. The emotion
surrounding this issue tells us something about the
current state of performance presentation practices
in the industry. The committee has looked at this
issue and listened to people on both sides.
The standards do not require verification, but if
composites are verified, they must be verified within
the guidelines incorporated in the standards. For
example, the verification must be performed by an
independent third party from either a CPA or a nonCPA firm. Internal compliance staff will not suffice
for verifying composites. Staff may simplify the task
for an outsider, which should lower the cost considerably, but that is not sufficient to be considered
independent verification. Verification can be done at
either of two levels. Level I requires that the verifier
look at the composite to verify that all of the portfolios that should be in the composite are there, that the
basic calculations conform to the standards, and that
the approach to the calculations is reasonable. Level
II is more rigorous because it includes Level I requirements but also requires testing the pricing system,
confirming that calculation methods are scrutinized
thoroughly, and reviewing all of the disclosures accompanying the composite.
Risk
AIMR recognizes that risk is an important component of investment performance and should be an
integral part of performance reporting. The standards address two aspects of risk measurement. The
first is external risk measures, which refer to the

traditional measures-standard deviation, beta, and
duration-that measure the riskiness of a strategy on
an absolute or a relative basis. These measures can
be used to describe the riskiness of a strategy and
compare it to an index or benchmark to show the
relative riskiness of the strategy within its environment. For example, a small-capitalization equity
strategy can be examined using volatility information, beta, and other measures that permit comparison to the S&P 500 or a more germane small-capitalization index.
The second risk measure focuses on a
composite's internal risk. This measure determines
the dispersion of results within a composite-that is,
the consistency with which a strategy has been applied within a composite. How well has the manager
managed all portfolios? Have they been managed
within the same strategy or have they been managed
differently, resulting in a different return on a quarterly and annual basis? Both the external and internal risk measures are important, and the standards
contain strong recommendations regarding them.
Conclusion
The standards are a manifestation of ethical principles of fair representation and full disclosure. They
are not the principles themselves, but a way of
achieving those results. The standards will evolve as
the industry, technology, and our understanding of
risk and return numbers grow. Currently, the standards exist to provide better communication of investment results, better understanding of the performance numbers, and full disclosure to prospective
clients of how those numbers are calculated.
91

Question: How and when are
the standards going to be enforced and against whom? What
about firms that are not AIMR
members?
Churchill: Technically, the standards apply only to AIMR members. The vehicle for enforcement
will be through the AIMR Standards of Professional Conduct,
which now cover performance
presentation under Standard III
F. Any enforcement actions will
be undertaken by AIMR's Professional Ethics and Responsibility
Committee. Peer pressure, we
feel, will be the most compelling
force driving adoption. As plan
sponsors, individuals, clients, and
investment managers show an interest in improved performance
reporting, a demand will be created for use of the standards. It
will also result in self-policing
within the industry.
The idea behind the standards is to define fair representation and full disclosure in reporting investment results. This industry is not generally characterized by intentional deception or
misrepresentation of performance
results, but there has been an inability to focus on what specifically should be targeted in presenting performance results. That is
the intent of the standards.
The SEC has an interest because the standards are a positive
step toward industry self-regulation, although the SEC is not interested in mandating our standards. Nevertheless, if a firm
says it meets the standards and in
fact does not, the SEC would
probably see that claim as misrepresenting the validity of the results. So although the SEC may
not directly endorse the stan92
dards, it will probably have some

role in enforcement by insisting
that any claim of conformance be
backed by actual conformance.
The SEC has requested and received copies of the Implementation Committee's report and appears to be interested in the evolution of fairer representation of
performance results going forward.
Question: How will a small consulting firm with limited resources and performance measurement capabilities be able to
satisfy the requirements? What
has been AIMR's response to the
concerns raised by large trust
banks <e.g., creating composites
for thousands of accounts and disclosing the changes and number
of portfolios measured)? Large
firms can have tremendous turnover, both in new clients coming
in and those leaving.
Churchill: The standards have
specific recommendations on
how to handle clients coming and
going, which is an ongoing issue
in performance presentation. For
a small money management firm,
several software firms have been
following the development of the
standards and have developed
software to aid in compliance.
This software is not a particularly
expensive component of running
a business. At the same time, if
the number of accounts is not too
large, it can be handled within a
data base program on a reasonably sized personal computer.
For a small number of accounts, a
simple spreadsheet can be used.
In either case, the solution is
fairly inexpensive. Most requirements are straightforward and do
not require tremendous collec-
tions of data.
As for bank trust departments, we have a subcommittee
working with several industry
representatives from trust departments to deal with the existing
problems. One typically voiced
concern is, "We have thousands
of accounts, and we do not calculate performance on them. What
are we going to do?" There are
two sides to that. There is no
legal requirement to meet the
AIMR standards, but if a bank
wants to meet them, it must
begin to look at ways to calculate
performance on thousands of accounts. That is less of a problem
than it seems when you consider
that a significant portion of those
accounts are nondiscretionary, because the bank, or a portfolio
manager, does not have the ability to implement fully an investment style within all of those portfolios.
Question: How are the consultants looking at the standards?
Churchill: The consultants I
have talked with are interested in
seeing the presentation of better
raw data, and the standards provide that for them. Consultants'
requirements will still be specific
to their situations, including the
calculation of returns within their
parameters. They have specific
number-crunching needs, which
in many cases go well beyond the
demands of the standards. The
standards allow the consultant to
see a standardized format for
those numbers. Most consultants
I have talked with view the standards favorably.
Question: Many institutions are
having trouble applying the stan-
dards, especially in cash allocation. Please clarify what must be

done to comply.
Churchill: Again, cash does not
need to be allocated within a balanced account. A balanced account is a total account as long as
you show total account performance, not just a part of that account. If you pull out part of the
performance, then you must allocate the cash. The one problem
area is how to do that for historical data. I have discussed this
with many different people, and I
now argue that it is probably impossible. You cannot re-create a
record and say, "We believe the
cash was allocated on a 50/50
basis between the equity and
fixed-income portfolios." That is
not representative of what somebody would have received on
that portfolio in the past, so it
does not truly represent what actually occurred in that subcomponent of a balanced account
on a historical basis. On a current
basis, cash can be allocated to balanced account subcomponents, although that requires some good
recordkeeping.
Question: Why do you say it is
clearly better to show returns before fees for private clients? Actual returns are after fees.
Churchill: The standards apply
primarily to prospective clients
and secondarily to existing clients. We feel that the gross return is most appropriate, particularly when a firm has more than
one fee arrangement, because the
fee probably is not the
same as the fees prospective clients will pay. By showing gross
returns plus a fee schedule, the

prospective clients can estimate
the net performance they would
have received.
Question: The standards do not
appear to recognize cash and
equivalents as a separate asset
class. It appears that cash must
be allocated to fixed-income and
stock portfolios. What do managers who treat cash as a separate
asset class in allocation do?
Churchill: The Implementation
Committee report contains a section that deals with those managers who are treating cash as a separate asset class. If you treat cash
in this way, nothing really
changes. In a balanced portfolio,
the dollars invested in cash or
cash equivalents may include an
allocation to cash as an asset
class. This is considered a strategic allocation to cash rather than
a frictional cash balance. 50 if
you have a 20 percent participation in cash or exposure to cash,
half of that may well be cash as a
separate asset class. The other 10
percent should be allocated to
fixed-income and equity assets
within that portfolio if you are
showing those asset classes separately. If they are not shown separately, the question is moot.
Question: Would it be acceptable to calculate quarterly returns
prior to January 1, 1993, and
monthly calculations from that
point forward?
Churchill: Yes, that is acceptable, but we encourage monthly
or daily calculations. Monthly
calculations improve the estimation of returns, and daily calcula-
tions improve it that much more.

Weare trying to achieve better estimation of return numbers. We
encourage moving from quarterly
to monthly, and then from
monthly to daily. (In a few years,
we will probably be discussing
going from monthly to daily as
opposed to quarterly to monthly
calculations.)
Question: How should accounts with asset class limitations
established by the client be
treated in a balanced composite?
Churchill: That depends on the
limitation. If the limitation is an
absolute one on the mix between
fixed-income and equity securities, then it is not a balanced account and should be broken into
its separate fixed-income and equity components and included in
the appropriate composites.
Question: If a portfolio is discretionary except that selling a lowbasis stock holding is not permitted, may the manager include all
or part of the portfolio in a composite?
Churchill: If a client has a low
cost basis or just happens to like
one of the stocks held in the portfolio and does not want it sold,
and yet the rest of the portfolio is
managed as if that stock did not
exist, then you could include the
majority of the portfolio in with
the composite return, excluding
that one stock. The balance of the
portfolio is fully representative
and should be included in a composite.
93
Self-Evaluation Examination
1.
Recent research indicates that most private clients have:

a.
relied on a consultant to find an investment advisor.
b.
recommended their advisor to a friend.
c.
fired their advisor in the past year.
d.
not talked with their advisor for more
than a year.
2.
Which of the following is not a kind ofestate and

gift tax shelter available to individuals?
a.
Annual gift tax exemption.
b.
Charitable deduction.
c.
Unlimited marital deduction.
d.
Use of living trusts.
3.
Individuals have a lifetime exemption from federal estate taxes in the amount of:
$200,000
a.
$400,000
b.
$600,000
c.
$800,000
d.
4.
5.
6.
94
A provision for a specified annual distribution

to a noncharity beneficiary for life with the balance held for the benefit of a qualified charity is
known as a:
a.
charitable foundation.
charitable lead.
b.
c.
charitable remainder trust.
charitable direct contribution.
d.
Which of the following is not a typical component of an investment policy for a private client?
Statement of investment objectives.
a.
b.
Statement of investment preference.
Statement of investment constraints.
c.
d.
Statement of investment philosophy of
the advisor.
According to Davis, investment managers must
be particularly sensitive to the:
a.
business life-cycle stage of the investor.
b.
current level of the stock market.
c.
activities of competing investment managers.
d.
level of interest rates on Treasury securities.
7.
The main taxes that influence investment returns include all of the following except:
a.
Capital gains tax.
b.
Dividend tax.
c.
Alternative minimum tax.
d.
Sales tax.
8.
Unrealized capital gains represent a valuable

tax shelter because they:
a.
allow growing assets to compound on a
nontaxable basis.
b.
are taxed at a lower rate than realized
capital gains.
c.
can be used to offset taxes on realized
capital gains.
d.
can be used as an itemized deduction.
9.
A tax strategy that leaves a portfolio of appreciated assets untouched but uses options or futures to hedge is:
a.
an interportfolio swap strategy.
b.
an overlay strategy.
c.
a loss realization strategy.
d.
an immunization strategy.
10.
According to BruneI, the key questions investment managers should ask about private clients
include all of the following except:
a.
Who are these clients?
b.
How much should these clients be
charged?
c.
What do these clients need?
d.
What are these clients looking for?
11.
Portfolio structure for a private client should accomplish all of the following except:
a.
make sense from legal and tax standpoints.
b.
coincide with other assets held by the client.
c.
satisfy income requirements.
d.
be consistent with portfolio structure for
other private clients.
12.
13.
14.
15.
16.
A private client's core assets should be:

a.
ignored by the investment counselor.
turned over to an advisor who specializes
b.
in those assets with no further consideration.
considered as part of the overall portfolio
c.
even though the advisor has no control
over the core assets.
d.
sold as soon as possible and reinvested in
assets that are more suitably managed by
the advisor.
The greatest effect on supply and demand in the
municipal bond market in the past 10 years has
been:
tax reform.
a.
economic recession.
b.
decline in ownership by individuals.
c.
increased domination by institutional ind.
vestors.
17.
a.
b.
c.
d.
18.
b.
Which of the following is not a characteristic of

venture capital?
Privately negotiated investments.
a.
Above-average return expectation.
b.
Long-term, illiquid commitments.
c.
High current income yield.
d.
c.
d.
19.
educating U.S. clients about the benefits

of diversifying internationally.
convincing U.S. clients that foreign investments provide high returns at low
risk.
determining the most suitable global investment approach for U.S. investors.
satisfying the special servicing needs of
U.s. clients with respect to foreign investing.
Among the issues that U.S. clients may worry

about with regard to international investing are:
a.
Which of the following best explains the current

overall condition of state and local government.
bonds?
Declining supply of issues.
a.
Enormous number of defaults.
b.
Loss of tax-exempt status.
c.
Deteriorating credit quality.
d.
The venture capital market can be characterized
as:
largely controlled by a small number of
a.
specialized advisors.
a primary source of funds for large dob.
mestic corporations.
an important and large investment outlet
c.
for individual investors.
relatively stable in terms of dollars raised
d.
each year.
According to Spirandelli, all of the following are

key challenges of advisors who offer global investment programs to U.s. clients except:
turnover, taxes, advisors' commissions,

and performance.
lack of diversification benefits because
foreign investments closely parallel domestic investments.
the declining amount and availability of
foreign investments compared to U.S. investments.
higher U.s. tax rates imposed on foreign
gains than domestic gains.
Private clients differ from institutional clients

because:
a.
b.
c.
private clients' money has "an ego."

private clients are less communications
sensitive.
private clients are less concerned about
their personal relationship with an adviSOL
d.
20.
Effective communication with private clients is

especially important during:
a.
b.
c.
d.
21.
private clients are more interested in relative returns, not total returns.
times when asset values are rising rapidly.

virtually every week of the year.
periods of uncertainty.
important holidays.
Private clients' product choices typically fall

into all of the following categories except:
a.
b.
c.
d.
commingled funds.
individually managed portfolios.
government (federal) managed portfolios.
mutual funds.
95
22.
What is the largest asset class in terms of dollar

amount for wealthy private clients?
a.
Bonds.
b.
Cash and equivalents.
c.
Corporate stocks.
d.
Real estate.
23.
Which kind of advisor provides the greatest

amount of personal financial planning to
wealthy private clients?
a.
Accountants.
b.
Attorneys.
c.
Financial planners and insurance agents.
d.
Stockbrokers and money managers.
96
24.
The AIMRPerformance Presentation Standards

require all of the following except:
a.
performance calculation using a timeweighted rate of return.
b.
presentation of performance results after
deduction of investment management
fees.
c.
within a composite return, portfolios
must be weighted by account size.
d.
results for a composite return must include the effect of cash allocated to each
asset class.
25.
Theemphasisofthe AIMR Performance Presentation Standards is on:

a.
performance attribution.
b.
performance measurement.
c.
performance presentation.
d.
risk measurement.
Self-Evaluation Answers
I.
b.
According to Beyer, research suggests that

most private clients have recommended
their investment advisor to a friend.
2.
d.
Individuals may not use living trusts as an

estate and gift tax shelter. See Levy.
3.
c.
Individuals enjoy a $600,000 lifetime exemption from federal estate taxes. See
Levy.
4.
c.
According to Levy, a charitable remainder

is a provision for a specified annual distribution to noncharity beneficiaries for life
with the balance held for the benefit of a
qualified charity.
5.
d.
Typically, an advisor's investment philosophy is not included as part of a private

client's investment policy. See Davis.
6.
a.
Davis maintains that investment managers must be sensitive to the business lifecycle stage of the investor.
7.
d.
According to Koontz, sales tax is not an influence on investment returns.
8.
a.
Unrealized capital gains are effective tax

shelters because they allow growing assets to compound on a nontaxable basis.
See Koontz.
9.
10.
II.
b.
b.
d.
An overlay strategy leaves a portfolio of

appreciated assets untouched, but uses
options or futures to hedge. See Koontz.
BruneI argues that investment advisors
should concern themselves primarily with
questions regarding who their clients are
and what they need, not how much to
charge them.
In structuring a private client's portfolio,
an investment advisor should be concerned about the client's specific needs,
not consistency among the advisor's accounts. See BruneI.
12.
c.
According to Miller, a private client's core

assets should be considered part of the
overall portfolio-even if the advisor has
no control over those assets.
13.
a.
Friedlander maintains that, in the past 10

years, tax reform has had the greatest effect on supply and demand in the municipal bond market.
98
14.
d.
Deteriorating credit quality best explains

the current overall condition of state and
local government bonds. See Friedlander.
15.
a.
According to Stone, the venture capital

market can be characterized as being
largely controlled by a small number of
specialized advisors.
16.
d.
High current income yield is not a characteristic of venture capital. See Stone.
17.
b.
Investments advisors who offer internationaI programs need to educate U.S. clients, determine investment approaches,
and satisfy clients' servicing needs-not
convince U.s. clients that foreign investments provide high returns at low risk.
See Spirandelli.
18.
a.
According to Spirandelli, U.s. clients delving into the international arena worry
about turnover, taxes, advisors' commissions, and performance measurement.
19.
a.
Private clients differ from institutional clients because private clients' money has
"an ego." See Murdock.
20.
c.
During periods of uncertainty, effective

communication with private clients is especially important. See Mead.
2I.
c.
Typically, private clients' product choices

include commingled funds, individually
managed portfolios, and mutual funds,
but not government (federal) managed
portfolios. See Helsom.
22.
c.
According to Helsom, corporate stocks are

the largest asset class in terms of dollar
amount for wealthy private clients.
23.
a.
Accountants provide the greatest amount

of personal financial planning to wealthy
private clients. See Helsom.
24.
b.
The AIMR Performance Presentation

Standards do not require that performance results be presented after deduction of investment management fees. See
Churchill.
25.
c.
AIMR's standards emphasize performance presentation. See Churchill.

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Investment Counsel For Private Clients 1993 Peavy

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ICFA Continuing Education

Investment Counsel for Private Clients

David L. Mead, CFA

Edited by John W. Peavy III, CFA

AIMR Education Steering Committee 1992-93

Charles F. O'Connell, CFA

Ian R. O'Reilly, CFA, Co-Chairman

Donald L. Tuttle, CFA

Charles D. Ellis, CFA

Eliot P. Williams, CFA

Lea B. Hansen, CFA

Susan D. Martin, CFA

The Association for Investment Management and Research

From a Declaration of Principles jointly adopted by a Committee of

ISBN-10: 1-879087-22-7 ISBN-13: 978-1-879087-22-4

Printed in the United States of America

Katrina F. Sherrerd, CFA

Investment Counsel for Private Clients-An OveNiew

Understanding Private Client Characteristics

Investment Planning for Entrepreneurs

Investment Planning for Wealthy Families

Asset Allocation for Private Clients

SeNicing the Private Client-Part I

SeNicing the Private Client-Part II

The Value of SpecialiZed Investment SeNices

Investing in Municipal Bonds for Private Clients

Investing in Venture Capital for Private Clients

International Investing for Private Clients

Understanding the Tax Constraints on Private Clients

(continued on next page)

Estate Planning and Charitable Giving for Private Clients

Portfolio Management for Private Client&-A Case Study

Applying the AIMR Performance Presentation Standards to Private Clients

ICFA Board of Trustees,

Thomas L. Hansberger, CFA

AIMR Council on Education and Research

Robert M. Luck, CFA, CPA

Katrina F. Sherrerd, CFA

the seminar and this proceedings. AIMR wishes to

Family Business Review and a series editor for the

William R. Levy is vice president of The Glenmede

Southern Methodist University. He also is on the

Investment Counsel for Private

toward investing and express interest in risk-return

Investment Strategy and Asset Allocation

are not all alike, a counselor must respond to each

A wealthy client or family may envision a pool of

Case Study in Asset Allocation

performance composite, which is the aggregation of

Understanding Private Client Characteristics

Today's private clients are different from

Myths of the High-Net-Worth Marketplace

managers do this? Because most believe they do not

them, and asking about the children or the summer

aftertax returns. 1 This is a major issue right now.

Working with the Private Client

Question and Answer Session

try? How do you reconcile your

cation./I Typically, advisors are

a difference. One member of the

Question: Do you think wrap

Beyer: Yes, but participating

Are fee levels import-