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Ferrell Asset Management Pte Ltd20 Cecil Street, #25-05 The Exchange, Singapore 049705Telephone: (65) 536 6623 Facsimile: (65) 536 1738Email: [email protected] Website: www.ferrell.com.sg

29 July 1999, Quarter 3By Dr David Lee

Asia Wealth Management- What they do not tell you about Asia

“The market behaves just like a spring. As the selling pressure exerts itself, it will coil up like a spring. The more the selling pressure, the more depressed the spring will be. The selling pressure will be there for weeks and once it is off, the spring would uncoil itself in a rapid fashion, springing surprise to everyone on its way up and overshooting the fundamentals.”

- A renowned financial advisor

This is a quote from a renowned trader and investor and this is what you seldom or indeed never find in any publications or textbooks. Asia, which accounts for less than 13 % of world equity market capitalisation and a minute portion of world fixed income market, requires a different approach in the management of individual wealth in a world of rapid leveraged capital flows. This article will outline the characteristics of Asian markets and investors. While the same phenomena exist elsewhere, they are more obvious in Asia given its small size relative to the large flow of world capital. It requires a different mindset in approaching the practice of wealth management.

Objective of a Wealth Manager

The objective of a Wealth Manager is to assist the investor, usually a high net worth individual, to manage the assets in order to achieve his objectives, given his preferences and constraints. Behind all investment portfolios, we have unique qualitative investment considerations reflecting the preferences and constraints of the individual investor.

The first step is to set an operation statement or devise a set of guidelines that specify the actions to be taken to achieve the investment objectives or goals, given the preferences and constraints. The constraints are limitations: legal, regulatory, time

Ferrell Asset Management Pte Ltd has taken all reasonable care to ensure that the information contained in this report is accurate. Any opinions expressed herein are given in good faith but are subject to change withought notice. No liability is accepted whatsoever for any direct or consequential loss arising from the use of this document. Ferrell Asset Management Pte Ltd and its directors, employees and associates may from time to time have positions in, and may effect transactions. This research report is prepared for general circulation. It does not have regard to the specific objective, financial situation and the particular needs of any specific person to receive this report. This document is not to be constructed as an offer or a solicitation of an offer to buy or sell any financial instruments".

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horizon, liquidity, or tax matters among others. The preferences are constraints that are usually self imposed: downside risk and degree of leveraging usually unique to the investor.

The objectives or goals are usually defined in terms of return requirements and risk tolerance. For every investor, the Wealth Manager has to translate the qualitative

considerations, i.e., preferences and constraints, to a quantification of risk and return. Ultimately, the Wealth Manager develops an efficient portfolio reflecting the needs and objectives of the investor. So before establishing any investment program, the Wealth Manager not only has to understand his clients, but also has to ensure that the clients understand what he is doing.

The next step is to develop the strategies and implement through the choice of optimal combinations of assets. Once the asset allocation is implemented, the Wealth Manager will have to continuously monitor the market conditions, relative asset value, as well as the investor’s circumstances. The portfolio will have to be adjusted accordingly to reflect the changing capital market and investor conditions. The Wealth Manager will spend the time monitoring capital markets, he or she has to be in close contact with the client to ensure that information about the portfolio and client’s circumstances are exchanged regularly.

While the role of a Wealth Manger seems closely related to that of a Fund and Portfolio Manager, there are differences. Indeed, a Wealth Manager concentrates on the risk tolerance and preferences of the clients. The focus, is therefore, the client. The main difference is, a Wealth Manager would not only have to assess the client’s asset and liability, and he has to know the client’s dreams, goals and fears. In order to clearly define the roles played by different investment managers, we look at the objectives of each type of managers.

The Fund/Money, Asset/Portfolio and Wealth Managers

Fund and Money Manager

Fund and Money Managers are professionals responsible for investment decision regarding the selection of individual securities such as cash, bonds, equities or/and alternative investments. Every fund manager has his own style, expertise or philosophy regarding investments and his main concerns are capital market conditions and investment mandates, nothing else. Their main task is to outperform the market or


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index and they would assume that clients have already made their own decisions on asset allocation.

If they are managing a bond fund, then they can take it that the portion of funds available to them has been allocated by the investor specifically for bond investment. In other words, the investors have come to them with their respective portion, each of them having the same preference and constraints. The job is then to deliver superior performance and concentrate on successfully implementing their philosophy. The practice of fund managers is to focus on implementing the projected philosophy. The practice of fund managers is also institutionalised in the sense that his performance is to be measured against other managers in the same asset class, e.g., bond.Portfolio and Asset Managers

Portfolio/Asset Managers, unlike Fund/Money Managers who focus on a single asset class, concentrate on allocation and management of multiple asset classes. They combine both client’s risk tolerance/preferences and capital market conditions with an emphasis on asset class/geographical diversification in investment. Portfolio Managers would have to structure and monitor portfolio consisting of cash, bond, equities and alternative investments. They have to assist clients in diversifying their portfolios by investing in different asset classes in various geographical markets. At the same time, they have to monitor the risk associated with each asset class and do the switching appropriately. The work is usually assisted by custom-made or in-house optimisation software.

Wealth Manager

Wealth Management focuses on clients and is a speciality of financial planning. The wealth management process involves data collection, goal setting, identification of financial issues, preparation of alternatives, recommendations, and implementation of periodic reviews and revision of a client-specific plan. The main difference between a Portfolio Manager and Wealth Manager is that the latter has no institutional clients, while the former can have corporate and institutional clients. Portfolio Managers can be external managers for financial management units of non-financial institutions. The practice of a Wealth Manager is holistic in the sense that every detail of the clients matters to him. This approach towards wealth management is also individually customised in the sense that success is not only measured by relative performance against other managers, but rather by client’s success in attaining his goals in life.


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While it is easy to know who a Fund/Money Manager is, it is harder to differentiate who a Portfolio/Asset Manager or Wealth Manger is. Many Investment Managers play different roles and even within the same unit of an investment management organisation, you may find a Fund Manager, a Portfolio Manager and Wealth Manager. At other times, a Fund Manager may play the role of a Portfolio Manager or a Wealth Manager when a portfolio is targeted at high net worth investors. Whatever it is, with financial planning and a change in market structure, a new class of wealth managers is emerging.

The Characteristics of Asian Investors

The most important first step in managing wealth in Asia is to provide a common reference point for discussion. While the sophisticated investors in Asia do think in terms of volatility and return, it is useful to relate what the investors say and feel in response to these concepts. Increasingly, more investors can understand the concept of standard deviation of return, systematic risk, unsystematic risk and currency risk.

But for most investors, especially wealthy individuals who are too busy or too disinterested in managing assets themselves, they prefer to refer to risks as:

1. Losing money

“Can lose money” is the most commonly used term to described “exposure to risk” and “lost money” is the term to use after the loss has occurred. The investors are usually more concerned with absolute amounts than percentages. If you are down 10%, it is usually harder to explain to someone with USD 10 mil than someone with USD 1 mil asset under management. Losing 1 million dollars is different from losing 100 thousand dollars, even though both account for only 10% of the assets under management.

Most investors do not consider paper loses as “lost money”, even though they are hopelessly under water. They hardly do any switching when there are other grossly undervalued securities. While it is not so easy to differentiate realised and unrealised loss apriori, we can look at risk as “losing money”. So risk can be more appropriately defined for Asian investors as

Risk = Average of negative deviations from the expected return

Mathematically, it can be estimated by


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Risk = N – 1 i I(ri - r) x [ri - r] (1)

where is the summation of returns r, from period 1 to N and I(.) is an indicator function with

I(.) = 0 if ri - r > 0 (no losses) andI(.) = 1 if ri - r < 0 (with losses)

and the mean is estimated using

r = N – 1 ri

which can be set arbitrarily to zero or the risk-free rate of return if desired.

This risk measure is different from the usual textbook variance/standard deviation widely used in wealth management software available to asset managers and trading desks. The standard measure of risk is

Risk = N – 1 [ri - r]2 (2)

The differences between equations (1) and (2) are

(1) Asymmetry: Only losses matter and gains are not classified as risks, as we are only summing negative deviations from the mean in (1). In (2), both losses and gains are summed. We are basically subscribing to the philosophy that “take care of the downside and the upside will take care of itself”. So risk is only on the “downside” and “upside” is no risk.

(2) Absolute: Only absolute losses matter in (1) and not the squares. There is no reason why we cannot penalise large losses by squaring the losses as in the case of (2). But in the first place, we have to challenge the convention of using square and not to the power of 1.5, 3 or 4.5. Why square the errors when we can take non-integer power or integer larger than 2? The answer lies in the fact that using squares as the power is merely mathematical convenience. For example, the derivative of a square function is also continuous. There are a lot of advantages in more advance analysis using a power of 2. When the practitioners and academics are limited by the computing power, using the power of 2 can be justified. Over here, there is no reason to choose this as computing power can now manage with fractional power or absolute value easily.


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Applying standard risk/return analysis using the standard variance may be useful for some investors in Asia, but most would not be impressed. The standard definition of risk may not be applicable in Asia and new techniques on semi-absolute variance (see Murtagh (1995)) as the case above has been developed to deal with the problem. This is so because most will consider risk as “downside”. It has nothing to do with whether the investors are sophisticated or not, it has to do with the market behaviour as well as abnormal asset pricing in Asia. Indeed, modern portfolio theory may not be modern anymore (see D Lee (1999a)) and Asia wealth management will take off as more techniques applicable to Asia are developed. Unless techniques peculiar to Asia are widely used by Wealth Managers in Asia, advisory accounts would remain the main force for wealth management and not many would entrust their money to the managers with full discretion.

2. Unfamiliar Instruments

The general view is that it is unwise to invest in instruments that cannot be fully understood. This is particularly true if the investor has read headlines in books or articles about risks in certain kind of instruments (see e.g., Partnoy (1998)). Portfolio insurance strategy whereby Wealth Manager can reduce risk through various options hedging techniques can be easily implemented. It may simply be buying put options to guard against downside risk and the maximum loss is just the capital outlay for the price of the option. The investors only to hear the term “derivatives” and they will turn away as they perceive that these are complicated and risky techniques, suitable only for aggressive investors.

In this case, the investor has some preconceptions about derivatives and the perceived level of risk. A professional with enough patience and knowledge can alter the risk perception of an investor, only if the investor has an open mind.

Being well-informed about home securities has also contributed to non-diversification/home securities bias phenomena. It is not uncommon for investors to concentrate on local securities resulting in inadequate diversification. First of all, the Asian market accounts for no more than no more than 13% of world market capitalisation (see Table 1). Excluding Japan, Asian markets account for no more than 5% of world market capitalisation. Second, most Asian equity markets, excluding Japan, are inherently narrow. Singapore, which accounts for no more than 0.5% world capitalisation, has 50% capitalisation in finance and


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property. Thailand, which is half of Singapore’s market capitalisation, has 60% capitalisation in three banks and 80% capitalisation in 5 companies. In Indonesia, 5 companies account for 50% of market capitalisation.

If one were to invest 100% in the USA, the home equity bias may not be a major problem as the market accounts for 53% of world market capitalisation and in view of the different hedge fund styles that one can use to diversify the portfolio. If one were to invest 100% in Singapore market which accounts for no more than 0.5% of world market capitalisation, then we are putting all the eggs in one small basket. It may be alright when the market trends up, but most do not employ market neutral/long-short strategy when market heads down. Home-equity bias could be a serious problem and the real risk is not perceived. Even if one were to diversify in Asia, it hardly proves the point as most Asian markets will be highly correlated during a crisis. Table 2 illustrates the contagion effect in the form of increased correlations among Asian markets.

3. “Unlucky” Perception Associated with Familiar Instruments

It could be previous losses associated with some familiar instruments and it is difficult to overcome the psychological impediments to invest again in something that had previously post losses. This can be brushed aside as unreasonable fear for unsophisticated investors. But even for sophisticated Asian investors, who can differentiate between earlier investments that post losses and the proposed new investments, the Asian fear of “unluckiness” will come back time and again to haunt the investor. The so-called “non-blending of the eight letters” (ba zi bu he) in Chinese is what investment professionals known as perceived unfavourable “prior probability”. The prior probability is such that the empirical evidence is against the investor several times before and when an unfavourable situation occurs, the investor’s behaviour is dominated by negative reactions. It works on the investor’s mind a lot more when the portfolio is down than when it is up, and

irrational investment decisions are usually made when the portfolio is down, making the “unluckiness” self-fulfilling.

4. Contrary Investing

Confident and sophisticated investors perceive lower risk when market falls to a level way below fundamental. But for many others, a falling market has no end and shrinking liquidity at this level is not a right time to invest as there is a high


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probability of losing money. Investing in a market at this level is a high-risk exercise for those who want to belong to the “crowd”. It is common for many investor to buy when there is ample liquidity in the market and when prices have moved up to a level way beyond fundamentals. Everybody has made some money in the market and the perceived risk is low. Being contrarian is painful as large capital flows can push markets to way below fundamentals. If there are no flexibilities for the wealth manager in protecting capital by keeping cash, it is likely that the Asian investor will redeem their money.

5. Potential and Actual Risk

Stocks may have a historical standard deviation of 20% but this may not be what the investor will experience within a year. It would not be a real problem if prices move up 100% in a year, as in most markets in Asia in 1999. The potential risk is always there but it may not be what the investor has in mind. Investors may believe that there are no risks in a rising market and there may indeed be none in the year but the potential risk is always there.

Meeting Investor’s Objectives

The practice of wealth management is challenging and has become more difficult with rapid information and capital flows. It has been two years since the Asian crisis broke out and the undoing of the damage done is much faster than most expected. It has become obvious that traditional belief of pure causal relationship from fundamentals or valuations to asset prices is flawed. With different characteristics of the Asian markets as compared to other developed markets, meeting clients’ objectives requires a different approach.

(1) Absolute performance

Clients in Asia pursue absolute performance and this is a consequence of the market behaviour. There are not many stocks in Asia that resemble Coca Cola, Intel, McDonald or Microsoft. There are evidence that stock prices have a mean reverting tendency, i.e., stock prices tend to overshoot the fundamentals on the downside, then reverse direction and overshoot on the upside, way past the fundamentals. However, stocks in developed markets can continue to increase their earnings as companies expand their businesses internationally. The “expected mean” that reflects the fundamental is trending up and therefore the reversion is to a trending mean.


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In most markets in Asia, mean reversion is obvious (Lee (1999b), Lee and Robinson (1996)). But few companies, like Microsoft, have an upward trending mean. A large number has a level mean. In other words, if you do not lock in your profits after overshooting on the upside, you will end up with a portfolio with negative returns in the next cycle. So, it makes perfect sense to go for absolute returns rather than an index benchmark, which tends to trend upwards in the long run in developed markets. A Wealth Manager has to recognise this and meet the client’s objectives by being more active than their counterparts in developed countries in managing the portfolio. It is hard to explain to clients if you have not taken profit at IDR 1600 for Bank Internasional Indonesia, which consequently falls to IDR 150. The number of stocks plunging 50% or more under normal conditions in Asia is not small, even when there is no crisis. The fact is once fundamentals for a stock change from good to average, or when it becomes over-owned by institutions, selling commences and the price of the popular Blue Chip (it turns Blue Black!) plunges in a thin market. Not all markets trend upwards in the long term.

(2) Modern Portfolio Theory is not Modern

The reverse causality of asset prices determining fundamentals is more important. Dual causality exists all the time, with fundamentals causal asset prices and asset prices causal fundamentals continuously in both directions. But the reverse causality from asset prices to fundamentals is much more prominent than the other way round, at least in Asia over the past two years.

The hedge funds world is familiar with this phenomenon and many have taken advantage of it and continue to generate superior returns. In other words, by influencing the asset prices, one can influence the fundamentals, which in turn affects asset prices. By pushing prices up in Asia over the next few months as opposed to pushing prices down as in July 1997, we can increase the wealth of the investors, which in turn influences the fundamentals of the companies and thus the share prices. Hedge fund Guru Mr George Soros called this “Reflexivity Hypothesis”, Mr Edgar E. Peters of PanAgora Asset Management called this “Fractal Market or Complexity Hypothesis”, and Mr Christopher May of Kriya Inc. called this “New Reality of Nonlinear and Disequilibrium World” (Soros (1998), Peters (1994), May (1999)).

All three of them, among others, have written best sellers to illustrate the same point: traditional fund management techniques do not work! The reason: the


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new paradigm of cyber finance. As a direct consequence of computing power and information flow through cyber space, the world has become inherently

unstable and complex, characterized by disequilibrium and nonlinearity. This phenomenon is especially obvious in Asia with its small market size.

What are still widely taught to most MBAs such as Capital Asset Pricing Model, Arbitrage Pricing Model, Efficient Market Hypothesis and the Black-Scholes option pricing model hardly work in the real world. Collectively they are known as Modern Portfolio Theory. But Modern Portfolio Theory, in this cyber age, is no longer modern as the foundation of its work is based on linearity and equilibrium. While it is difficult to disprove the existence of equilibrium, the linearity hypothesis has been easily refuted by various simple tests.

The key difference between traditional and alternative fund management techniques is the emphasis of equilibrium/linearity as oppose to disequilibrium/ nonlinearity. With the former, the most efficient solution can be found with an ideal risk/return tradeoff. It can also be more complicated with multiple solutions, but straightforward solutions can always be obtained. With the latter, only strategies work as one simply has to react to different situations as observed in an inherently unstable and complex market with no pre-determined solutions.

Long memory, mean reversion, Hurst exponents, fractional integration and Chaos are key words that have been used repeatedly. Though widely used as trading techniques (e.g., KAOS in Bloomberg), it is never easy to understand what they are, not unless you have a strong mathematics and statistics background. As a Wealth Manager, one has to continuously upgrade oneself in “Cyber Finance” theory to service clients well.

Some time in the future, Asian Wealth Manager will have to develop their own risk management and wealth management software to deal with these anomalies. In the interim period, recognising the shortcomings of current available theories and guarding against inappropriate techniques for practitioners will be crucial in dealing with clients’ assets.

(3) Principal Protection and Diversification

The quotation of the investment advisor at the beginning of this paper has given us a good picture of the Asian markets. However, it would be more appropriate to put it in the following way to take into account leverage (Lee (1999b)):


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“Large capital flows cause markets to move in the same direction making it a one-way bet for speculators and investors alike. Initially, the correlations among the markets are not strong. As the contagion spreads, the profits of the market timers were accumulating and bigger bets were placed. There would be a point where “saturation” was reached and almost all the market participants were among a few large institutions with very little participation from others. The

feeling of “control” was there and the markets were “cornered” and had overshot their fundamental values on the downside (upside). As their confidence grew, the springs were coiled (stretched) and the markets were depressed (extended) with artificial strength through more leverage. The bets got bigger and when this group stopped trading, the depressed (stretched) springs would uncoil (release) and the markets would spring up (shrink) with tremendous upward (downward) force.However, not all markets can behave this way as those with their springs damaged and could not shoot up as much (e.g. Indonesia). Markets with spring mechanism working would finally have their glitters back but markets with failed mechanism would have to live with it till the springs are fixed and functioning again, if they can.”

One of the most important objectives for clients would be to risk-manage the wealth. Ask the client the level of risk tolerance rather than marketing the level of expected return. Protecting the downside is more important as venturing into the Asian markets is like venturing into a minefield. If you are careless, you may not only lose a leg or two. While it may not be as treacherous as it sounds in practice, there is no excuse not to protect the downside if the portfolio is skewed towards Asia.

Finally, there is no reason to put more than 70% of the assets in Asia, even if Asia has the highest rate of growth. The importance of diversification cannot be ignored.

Conclusion

In short, a good wealth manager must also be a good counselor. A good Asian Wealth Manager must have excellent product knowledge, a good understanding of Asian markets, good downside risk management skill, good portfolio management techniques, and most important of all, he must be a good listener. A Wealth Manager must not only listen to the client and ask the right questions to fully understand his fears and reasons, he must also be able to modify the client’s perceptions and


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implement the strategies accordingly. At the end of the day, the client’s needs have to be satisfactorily addressed and objectives achieved.

ReferencesLee, DKC (1999a), “Asian Wealth Managers: Will those Who Know Hesitate to Share?” Ferrell Quarterly Outlook.Lee, DKC (1999b), “Long Memory and Asian Crisis: Implications for Capital Controls and Management”, Paper Presented at the Econometric Society Meeting, Preprint.Lee, DKC and Robinson, P (1996) “Semiparametric Exploration of Long Memory in Stock Prices”, Journal of Statistical Planning and Inference, 50, 155-174.May, Christopher (1999), “Nonlinear Pricing”, Wiley.Murtagh, Bruce (1995), “A Downside Risk Approach to Asset Allocation”, Preprint, Macquarie University.Partnoy, Frank (1997), “F.I.A.S.C.O.: Blood in the Water on Wall Street:, Norton, 1997.Peters, Edgar (1994), “Fractal Market Analysis”, Wiley.George Soros (1998), “The Crisis of Global Capitalism”, Little, Brown and Company.

Note: This article is dedicated to Mr KC Yeo, who has taught me all I know about trading strategies and market anomalies.


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Figure 1: Trending Market Vs Level Market Over Time


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Compounded returns over time

Expected Mean over time

Compounded returns over time

Expected Mean over time

Level Market

Trending Market


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