The Wealth Advisor: Trading Up

Middle class millionaires are very keen to get alternative investments in their portfolios.

When it comes to investment choices, the newly, and relatively undiscovered, rich are starting to emulate the patterns of the more established rich. They want hedge funds, funds of funds and private equity funds. And they want them now.

Their soaring interest in alternative investments represents a sizeable opportunity for registered reps, especially in light of this group's heretofore-limited interest in such products. But only those reps who understand all the options and can decide which funds, if any, are right for the newly affluent will benefit. Reps who want to maintain, extend or begin relationships with these clients, who we call middle class millionaires, must have the resources to deliver a full line of products from both boutiques and the more established financial services firms.

In our third and last article recapping our research into these off-the-radar investors, we focus on the changing appetites of these middle class millionaires. This group is comprised largely of business owners, executives and professionals who gradually, and almost unexpectedly, became wealthy through their salaries, long-term investments, pension plans and inflation.

The research, commissioned by Merrill Lynch Investment Managers and conducted by Prince & Associates late last year, shows that in general, the 329 investors surveyed didn't think of themselves as being rich, even though they had at least $1 million in liquid assets not in a retirement account. (About one in five had more than $3 million.) And in the battle to land affluent clients, these investors fall somewhat under the radar compared to the baby boomers who stand to inherit a bundle from their parents or who became wealthy during the stock market run of the late 1990s. Nonetheless, it may well prove to be the largest source of new millionaires for registered reps and financial institutions.

Great Buzz

Importantly, they wanted to take the next step on the investment front, moving toward products that are traditionally reserved for the affluent and away from products, such as mutual funds, in which anyone can invest. The decision was based in part on the cachet of alternative investments — they have a great buzz. These clients also believe that they need to have more money to get access to the best money managers.

Whatever the thinking, our research showed there was an enormous gap between the investment products that middle class millionaires had and the ones they wanted, as the chart on page 73 illustrates. It's also important to note that, based on a number of other studies of the affluent that we've undertaken over the last few years, middle class millionaires are far from alone when it comes to an interest in alternative investments and, in fact, the more money investors had, the higher their interest level. See the chart on page 74 for the findings of one 2000 study of investors with an average of more than $10 million in investable assets.

Moreover, in a second study in 2000 of another group of the newly wealthy (388 people who had inherited at least $1 million in the prior three-to-five years), 83 percent said they expected their advisors to give them access to otherwise unavailable investments. All the findings also demonstrate a new level of overall awareness on the part of investors of every stripe. As recently as five years ago, they probably would not have contemplated — or even heard of — alternative investments.

We asked the middle class millionaires what attracted them to the various alternative investments and their top answers are listed below. In brief, they liked hedge funds because they thought that was where the best money managers ended up, an impression reinforced by articles in the financial world regularly announcing the departure of top money managers who are moving on to start their own hedge funds. They were attracted to funds of funds because they let them diversify across hedge funds.

And, although the barriers to entry are being lowered, not many people can afford to get into more than one hedge fund. In some cases, when a fund is not registered with the SEC, only “accredited investors” with a net worth of at least $5 million are eligible.

Lastly, though the private equity side has lost some of its luster from the dot com days, there is still the thrill of getting into a company early on, before the average investor has even heard of it, and of being able to dilute the risk by investing in a fund of such companies.

Hidden Millionaires Eye Alternatives
Currently Use Interest in Future Use
Hedge funds 3.0% 55.9%
Funds of funds 32.2% 0.6%
Private equity funds 42.2% 0.0%
Source: Prince & Associates, 2001 study of 329 investors with at least $1 million in investable assets.

Reps' Responsibilities

What does all this mean for financial professionals whose clients are new to the ranks of millionaires? First, those reps have to be able to deliver a concise explanation of the pros and the cons, the risks and the rewards, of the three alternative investment options relative to each client's understanding of, and expectations for, those products. Each registered rep will be the best judge of how informed a client is, but the odds are good that those clients are often intrigued by the cachet of alternative investments and have not fully thought through whether or not it is really the right choice for them.

The Obviously Rich Are Committed to Alternatives
Currently Use Interest in Future Use
Hedge funds 3.2% 81.4%
Funds of funds 69.6% 8.3%
Private equity funds 53.7% 6.1%
Source: Prince & Associates, 2000 study of 652 investors with an average of more than $10 million in investable assets.

Second, reps should explain how the alternative investment fits in with the rest of a client's portfolio. As often as not, clients will have to shift money from another investment to make an alternative investment, so they need to see how it will affect their overall asset allocation and diversification as well as their long-term goals.

Finally, whether it is hedge funds, funds of funds or private equity funds, a registered rep has to have the resources in place to deliver at least a short menu of alternative investment options. Our research over the last several years has shown that newly affluent clients in particular are likely to change advisors when they come to realize they have become rich, wanting a rep that has other rich clients — people like them. (In fact, in some cases, our research shows that clients will change reps no matter what because they feel strongly that their new status and stature entitles them to a higher grade of financial professional. They do not want to work with someone who reminds them of where they used to be financially).

If a rep doesn't have the experience or can't deliver the goods, they will find one that can. If a rep hasn't actually put a client in hedge fund, they should find a fellow rep who has and get some guidance. It's worth the effort because, once clients have entered seven-figure territory, reps don't want to lose them.

Writers' BIOS:
Hannah Shaw Grove
is a managing director at Merrill Lynch Investment Managers.

Russ Alan Prince is president of Prince & Associates.

Why Hedge Funds?

*83%: access to the “best” money managers

*77%: performance-based fees

*53%: flexible investment strategies

*38%: low market correlation

Why Funds of Funds?

*76%: diversity

*70%: professional selection of products

*60%: performance-based fees

*30%: “mutual fund” concept

Why Private Equity Funds?

*84%: can invest in pre-IPO companies

*54%: performance-based fees

*53%: professional selection of managers

*52%: risk protection against a single company failing

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