A few months ago we ran a story about the relationship between wealth and investment products based on research conducted by Prince & Associates Inc. "Eye Of The Beholder," Aug/Sep 2007). In it we noted that as wealth increases the interest in mutual funds declines. As evidence, 16% of investors with a net worth of between $1 million and $5 million expressed interest in funds while none of the investors with net worths in excess of $10 million did. Products with much higher levels of interest among the affluent were more tailored vehicles such as separate accounts, and higher-octane options like hedge funds.

We believe that future interest in mutual funds is muted based on the high incidence of ownership; if affluent investors have owned mutual funds for years, or decades, the learning curve has probably been scaled and appetite has likely diminished. Nonetheless, the research has provoked some debate in the industry, and more than a little curiosity. In an effort to shed light on the role mutual funds can and often do play with the affluent, we spoke to some investment professionals and advisors to get the frontline perspective.

In all cases, the professionals we interviewed were quick to point out their use of many different investments for their ultra-high-net-worth clients and that achieving a client's objective-say adding alpha while reducing risk-is more important than the specific vehicle used to do so.

PW:  In what cases do you recommend mutual funds to your ultra-affluent clients?

"If we found out a mutual fund had a large capital-loss carry-this means the fund would have reported losses on their books and future gains could be offset by these losses thereby reducing the likelihood of a capital gain distribution. In instances like these, mutual funds can be more tax efficient than a separate account."

"To access areas of the market where the cost or research requirements eliminate our ability to add alpha, such as foreign or emerging markets equities or currency strategies."

"Mutual funds are a means of accessing highly opportunistic long-term investment practitioners who only manage separate accounts with extremely high minimums. For example, Longleaf or Third Avenue Value both practice a thoughtful long-term investment discipline that is as good as anything available in the industry. Offering their investment process in a mutual fund form allows these groups to stick to the management of money and spend less time dealing with the administration and complexity of managing a large number of relatively small accounts."


"In cases where we would like exposure to a niche area of the market, but it would not make sense to buy individual holdings due to the lower level of assets available for investment."

"For certain portfolios that require broader diversification than is realistically possible given the nature of the portfolio. For example, our real return fund, which owns positions in precious metals, agricultural commodities, and industrial commodities both in the form of contracts or the stock of companies in that industry, could not be easily constructed for an individual client in a separately managed portfolio. Therefore, a mutual fund format would make the most sense to implement a broadly diversified commodities strategy."

PW: Do any of your ultra-affluent clients currently own mutual funds? And why?

"Actually, many of our clients own mutual funds. They are a good way to access established, excellent managers with long track records and funds give an investor the ability to own a well-diversified portfolio within an asset class that cries out for a diversification of positions. "Often times we use funds as part of the portfolios we create. We manage the core of our clients' assets in-house, but use outside managers to help diversify appropriately. For taxable investors we do a little extra work on transparency and tax efficiency, but, in certain instances, mutual funds provide the best access to a particular asset class or style."

"Some of our ultra-high-net-worth clients use mutual funds to access specialty-asset classes like international real estate, international bonds,130/30 equity exposure and emerging markets where considerations such as lower dollar amounts and portfolio diversification drive the decision-making process."

"We utilize mutual funds as part of a multiclass asset portfolio for our clients because the format is simply the best structure for certain strategies. Mutual funds also have the benefit of having the investment management fees charged to the fund, thus making them somewhat tax deductible as opposed to individually managed portfolios under which investment fees may not be deductible."

PW:  Do you ever recommend mutual funds over other types of products?

"We can recommend mutual funds without being subject to the large dollar minimums that, for example, many separate account managers impose. This gives us the ability to create diversification not only within a specific asset class or sector, but also by fund manager."

"No, we believe that high-net-worth individuals have better options, like separately managed accounts. Professionally managed portfolios are tailored for individuals, so they can be managed tax efficiently. We believe that portfolios should be diversified enough to mitigate unsystematic risk, but concentrated enough to amplify success. A careful manager can do this with a portfolio of only 10-15 stocks. So the short answer to your question is this: we don't believe that mutual funds are a good enough investment for wealthy individuals."

"If the funds have low fee structures and have substantially outperformed their separate account or ETF equivalents, we will use them to give our clients exposure to foreign bonds and currency. This also enables us to add non-correlated assets to our portfolios without the liquidity concerns that may exist with hedge funds or separate accounts."

"Yes, for example, international multicurrency investing is best achieved within a fund format. Gaining international exposure though ADRs is very limiting and private partnerships can be complex from a tax and administrative perspective."

PW:  What challenges do you face when recommending mutual funds to your affluent clients?

"We evaluate the value a portfolio manager brings to the table in the context of an inefficient market and relative to any additional expenses incurred within the fund. With taxable accounts, the concerns are turnover in holdings and the realization of gains."

"In my experience, most high-net-worth investors are often reluctant to have a substantial portion of their assets in mutual funds because of how limited they are when it comes to tax planning. Wealthy investors also enjoy a certain level of exclusivity in their investments that they don't associate with mutual funds."

"Rightly or wrongly, mutual funds have a reputation of being the vehicle for small investments in the stock and bond markets. We often find that ultra-wealthy investors perceive funds are boring, loaded with fees and highly inefficient when it comes to taxes. Our job is to help our clients understand the rationale behind our decision and the role funds will play in achieving their overarching objectives."

"The biggest challenges tend to be psychological. Some people feel that mutual funds are not high-end enough. In fact, a lot of the folks who feel that way would not hesitate to own a hedge fund and we point out the contradictions in that logic. Some clients like owning individual securities and we point out the benefits of spreading your bet when you are taking a position in an asset class that might be inherently more volatile than most. Finally, sometimes there is a cost issue that we address, at least partially, by obtaining access to the institutional class of shares."

On a related note, the survey found that exchange traded funds (ETFs) enjoyed higher overall levels of interest from wealthy investors than mutual funds did while still remaining low relative to other products. Given the similarities between mutual funds and ETFs, we asked advisory professionals to weigh in here as well.

"We use country-specific ETFs for exposure to countries that we are especially bullish on or sector ETFs for diversified exposure to attractive sectors that don't have enough individual stocks that meet our fundamental criteria. I also favor ETFs for their increased liquidity because it significantly streamlines the transition process for clients when new investment opportunities arise. "

"ETFs can be a relatively low cost and tax efficient way of maintaining a core exposure to the markets. They may also be a very good way of making a tactical bet on a particular area of the market."

"Generally speaking, I find ETFs preferable to mutual funds. The internal expense ratio is much lower with ETFs and more easily quantifiable. They are priced four times a minute during the trading day so we always know the price for our transactions. This allows us to use limit orders for purchases and sells and stop limit orders to protect our holding. ETFs are more tax efficient than mutual funds, and without the mandatory distributions of mutual funds we can control our clients' taxable events more effectively. Finally, because ETFs trade like stocks we can hedge our positions. Some ETFs have an option market and that allows us to write covered calls to increase income or use equity collars to protect the holding."

"Combining high-quality mutual funds and ETFs within a high net worth client's portfolio can serve the purpose of reducing risk in most market conditions while we attempt to outperform the relevant index."  

"When we don't believe management can add value in a niche market, we turn to ETFs. They allowing us to refine the position we want to take and achieve diversification within just the right area of the market. We also use ETFs in scenarios that call for trading in and out of positions quickly. Specifically, we've found ETFs to be useful when we want to track the price of a given commodity or basket of commodities. Firm values can vary wildly based on variables such as management, political factors, or regional weather patterns in sectors like mining and agriculture-ETFs help us maintain our equity positions amid the volatility."

"We use ETFs as place holders while we build out positions in specific securities. We also use ETF shares when we take a tactical position in a sector or asset class. They provide terrific flexibility and are efficiently priced."

Consider distributions of principal at various ages so that the trustee can observe how the beneficiary handles money. It is not unusual for young heirs to regret foolish expenditures or decisions. By the time the next distribution of principal is due, they may have learned from their mistakes and be ready to handle greater portions of their inheritance. A key to a successful incentive trust is an impartial trustee who cannot be controlled by the beneficiaries. Corporate trustees such as banks can detach themselves from emotional blackmailers who might unduly influence a family trustee.

Protecting The Trust For The Future
An incentive trust may last for several generations, and, ideally, the trust document should be written broadly enough to deal with unforeseen circumstances. Recognize that what is appropriate today may not apply tomorrow. One way to deal with the changing family dynamic is to name a trust protector who can change the trust guidelines to meet future or unanticipated needs. A trust protector or advisor can be a senior family member or family friend who can provide insight about a beneficiary's needs or problems. Alternately, the grantor can provide for a board of several trustees or an advisory council who has the power to amend the trust. Including one trustee elected by the beneficiaries may avoid a future court battle by heirs looking to break the trust.

Lastly, it is important that the grantor communicate his or her personal goals and provide written guidance that the future trustee can rely on. This might be in the form of letter to the trustee that expresses what is important to the grantor and how he or she feels about issues the trustee might encounter. The incentive trust is the grantor's legacy, and it should be a positive message to the next generation that will inspire them to make the best use of the wealth that is given to them.