Most financial advisors will recommend a portfolio allocation based on some sort of formula, be it a simple 60/40 formula (60% stocks, 40% bonds), a 1/3 formula (1/3 each in stocks, bonds, and money market funds) or an advanced formula that is based on some fancy (but undisclosed) mathematical model to calculate the (assumed) risk of various asset classes. They will also recommend that you keep all your assets with them to “optimize the cost structure” and “make life easier for you”. They call the resulting investment “diversified”. Nothing could be further from the truth. Before you even think about asset allocation you have to understand three main risks that hardly any financial advisor – be it a CPA, a CFA, a PFS or just some guy with a big mouth – will tell you about: Custody risk, fiat currency risk and jurisdiction risk.
Being the legal owner of an asset, you should always have the right to access it and sell it as you please. Unfortunately, this is not always the case. First, despite your firm conviction you might not be the true legal owner of the asset but might only have a claim on the asset or an equivalent amount of money. Second, even if you are the legal owner you are still exposed to insolvency, negligence or fraudulent action by the entity holding the asset. This is called custody risk.
Buying a security from a bank, a brokerage or an investment advisor and keeping it in their custody doesn’t necessarily imply that you are the owner of the asset and can sell it any time. The security is usually registered in the name of the custodian on the issuer’s books, and your custodian holds the security for you in “book-entry” form. This means that you do not receive a certificate and the custodian keeps a record in its books that you own that particular security.
If you purchase a stock outside of your home country the stock is usually not held directly by your financial service provider but a custodian of it in the other country. If you buy a fund or ETF the underlying securities are held by the fund/ETF management company. In the case of a synthetic ETF the ETF doesn’t even hold the securities directly, but only has a claim to another party backed by some form of security with “similar risk structure”. It can get a lot more complex if you consider the trillions of derivatives involving many players, that only math PhDs understand (or maybe not even them). But by now you probably get the picture. There is substantial counterparty risk in our financial system. If one party goes down there will be a domino effect. That is the reason why everyone was so scared in 2007-09.
Custody risk does not only apply to securities but also to physical assets. Many people who have bought gold from a bank and pay monthly storage fees think that they own gold. Unfortunately, this is not necessarily the case. In the Silberblatt vs. Morgan Stanley Class Action lawsuit the plaintiff claimed that Morgan Stanely’s customers were “misled into believing that specific bars or units of precious metals were allocated to them and, therefore, not subject to claims of creditors of defendants.” The bank denied allegations but decided not go to court and instead settle for a USD 4.4 million payment in 2017 “to avoid the cost and distraction of continued litigation”. Do you believe this explanation?
Another case involved Xetra-Gold, a fund that has Deutsche Bank as it’s designated sponsor. The fund claims that “for each Xetra-Gold bond, exactly one gram of gold is deposited in the central vaults for German securities in Frankfurt” and that “investors always have the possibility of demanding delivery of the securitised amount of gold”. In 2016 a customer of Deutsche Bank was denied physical delivery even though the “gold” assets managed by Xetra-Gold were valued at EUR 3.5 billion at the time. It took Deutsche Bank a while to officially comment on this and when they did their statement included the following remark: “If in specific cases the request of the investor for physical delivery of gold cannot be accommodated immediately this will be investigated and an individual solution with the investor will be found”. That sounds very reassuring, doesn’t it? So be aware that if you buy “paper” gold you might not be the real owner of bullion but rather an unsecured creditor of a bank or a fund.
As long as the economy is doing fine, custody risk usually does not materialize except for some cases where the market moves in a direction that financial institutions didn’t expect. Several large funds and asset managers have rejected withdrawal requests in the past few years. In 2015 Third Avenue blocked redemption of its USD 788 million Focus Credit Fund (FCF). The following year the three largest UK property funds froze USD 12 billion in the wake of Britain’s vote to leave the European Union. In 2018 GAM Holdings, a company with about USD 165 billion under management, announced that it had stopped withdrawals in some of its bond funds after a surge in redemption. And this year the USD 4 billion Woodford Equity Income Fund blocked withdrawals from April onwards. Investors eventually got part or all of their money back but they had to wait months. Once a real financial crisis strikes many funds and advisors will be forced to block redemption and this will have disastrous consequences for you. Think about it, if you lose your job and therefore can’t pay your mortgage, your bank might foreclose and you will lose your home even if you have the necessary amount of money in your frozen brokerage account.
At a time of declining business ethics and loose oversight (at least for the big players) there is growing custody risk due to fraud. You might remember the case of Bernard L. Madoff Investment Securities LLC that ran a Ponzi scheme costing its 4,800 clients about USD 65 billion. There are plenty of similar examples all over the world. Once the economy turns, more cases of deception and gross negligence will be exposed. Be aware that despite monthly account statements issued by your bank or financial advisor you can’t be 100% sure that the securities listed were really bought for you and that they haven’t been sold or “lent” in the meantime. Especially the latter is an issue. Most funds and ETFs are engaged in securities lending, just read the fine print. And who can guarantee that your broker or advisor doesn’t do the same without your knowledge and approval.
If you want to invest in securities you can’t avoid custody risk. What you can avoid is placing all your money with just a single custodian. Your financial advisor or your house bank will urge you to invest only with them. Allegedly this is to reduce fees and obtain better service. In reality they are trying to maximize their own commissions by increasing your risk. If they get into difficulties and freeze redemptions you will have no access to your funds for many weeks or even months, if they go bust you can lose everything. As shown above this is not completely unrealistic but has happened even with well-known companies and will most probably happen more often in the future. If you keep all your cash, fixed deposits, bonds, stocks and even your safety deposit box with the bank around the corner (because you and the bank manager are in the same football team, your wife and his wife are close friends, and your kids attend the same school), then you better act immediately and allocate at least some of your money to another financial institution (then you will also find out, whether the bank manager and his family are real friends).
Fiat currency risk
The money we use currently is not backed by any physical commodity. Instead it is so-called “fiat” money issued by our governments (or rather our central banks) and only backed by …… trust. This trust has already been eroded as central banks officially target a yearly inflation rate of 2% and have embarked on unrestrained money printing (called “Quantitative Easing”) as well as ultra-low or even negative interest rate policies. Money kept in cash or a savings account is certain to lose value on an inflation adjusted basis. The loss will widen in the future as central banks and governments are about to embark on a new phase of monetary experiments. It is foreseeable that people will eventually lose trust in their fiat currency and as a consequence inflation will surge and perhaps even reach hyperinflation territory. History has taught us that fiat currencies eventually fail, sometimes in a spectacular fashion. We have seen it in in the 1920s in Germany and most recently in Zimbabwe and Venezuela. Expect it to happen again within your lifetime.
The people most affected by high inflation are holders of cash, savings accounts and bonds. As these assets are denominated in fiat currency their value will be wiped out. Holders of life insurance policies will also be affected as inflation adjusted capital returns of the insurance companies will be insufficient to pay adequate returns.
Even the holders of stocks are likely to be affected by a collapse of the fiat monetary system and the accompanying economic recession or even depression. Ultra-low interest rates coupled with excessive money printing over the past decade have boosted most stock prices substantially above their fair value. Once Western fiat currencies fail, stock prices are likely to go down at least in real (= inflation adjusted) terms and dividends will be reduced or suspended. It is likely that many brokers are going to temporarily freeze redemption and some might even go bust. . People who hold most or all of their assets in fiat-related assets will be in for an ugly surprise.
Many people have all their assets in their home country. Their house – in which they keep some cash and gold – is located there, they have opened accounts with the bank around the corner and a domestic internet bank, they regularly pay premiums for a life insurance maintained with a domestic insurance company, and they invest their remaining funds with a local brokerage that keeps the money with a domestic custodian. Towards friends they claim to be internationally diversified as they have bought a global equities ETF, an emerging market infrastructure fund as well as USD, EUR and JPG bond funds. But in fact, they keep 100% of their assets in their home country and therefore are 100% subject to the respective regulations and taxation. We call this jurisdiction risk.
Being heavily exposed to a single jurisdiction can have devastating consequences. To prevent bank runs and capital flight, governments have started to reduce the free use of money. Larger cash deposits or withdrawals usually require a lot of paperwork or are even impossible. More restrictions are being prepared. The example of Greece shows how this can have a deep impact on the life of its citizens. To deal with the economic crisis of 2015, the Greek government decided to limit weekly ATM cash withdrawals to 420 EUR, severely restrict credit/debit card use abroad and enacted other far-reaching capital controls. It can happen tomorrow in our home country.
In view of record debt levels and an economic downturn ahead, it is just a matter of time until governments in the West will start to raise taxes (especially on real estate that by definition can’t run away). But they won’t stop there. By promoting zero or negative interest rates, governments have already stolen billions from savers. They will have no scruple to enact measures to expropriate additional assets either covertly or openly. This will mostly affect the middle class whose dwindling size makes it a less important electoral base. The Poor will not be affected as they don’t have noteworthy assets. And the Rich will be equally unaffected as they have already shifted their assets to safer jurisdictions or will influence the legislation in their favor.
This is not even the worst case. If you have the wrong race, religion, sexual orientation or political belief or if you are just a little too “affluent”, a change of government might result in all your assets being confiscated. History is full of respective examples. Look at Nazi Germany, Bolshevik Russia or Maoist China to name just a few. But this is not just a matter of the past. If you are white and own land in South Africa, expect it to be expropriated in line with what has already happened in Zimbabwe. In many Western countries we are experiencing the rapid growth of populist parties with radical political agendas. With the economic situation worsening their influence is likely to grow. If you have all or most of your assets in one country you definitely need to look for a plan B.
The above table gives a simplified overview of portfolio exposure to custody, fiat and jurisdiction risk. Brokerages and banks are certain to object that stocks and other securities belong into box 2 and paper gold into box 5. This can be argued but in view of the examples given above we have decided to place them in box 1. In normal times investments in box 1 are fine. But we don’t live in normal times. With severe economic trouble ahead, it is essential to hold some investments outside the fiat system and also ensure direct ownership and possession.
With very few exceptions financial advisors will only offer you investments in box 1. They will also try to persuade you to invest most or all of your money with them. They call the resulting portfolio diversified. We call it highly risky and their behavior reckless. If the fiat system breaks down, counterparties go bankrupt or local governments starts confiscating assets, you are likely to lose most or all of your money.
To prepare your portfolio for the uncertain and likely tumultuous times ahead the following diversification is prudent:
- Diversify between custodians as every service provider is vulnerable to bankruptcy, confiscation or fraud. In particular don’t keep all your money with a single bank and all your stocks/bonds with a single broker
- Diversify away from fiat assets as there is a high risk that the main fiat currencies such as the USD, EUR, AUS, CAD, JPG will fail. Consider investing part of your money in physical gold/silver and also in some cryptocurrencies
- Diversify internationally by holding assets around the world as the situation will likely differ between countries. Having assets away from home might help you to move abroad if the situation in your home country becomes intolerable.
In the next blog we will take a closer look at each of the main asset classes.
Disclaimer: The above is for informational purposes only. It is not an offer or advice to buy or sell any products or services. LBB and its owner do not provide investment, tax, legal, or accounting advice. Neither the company nor the author is responsible, directly or indirectly, for any damage or loss caused or alleged to be caused by or in connection with the use of or reliance on any content, goods or services mentioned in this article.
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