The Affluentialist

The premiere (May 2007) issue of Portfolio magazine, the $125 million business journal from the people who bring you The New Yorker and GQ magazines, opens with a story about the modern derivatives market, or as the magazine calls it, the “$300 trillion time bomb.”

Derivatives—financial contracts whose value is determined by, or derived from, an underlying asset—have indeed become a huge market on Wall Street, responsible for significant profits globally. While this article raises some valuable concerns about the unknown implications of these instruments, the derivative market has only been around for about 25 years, substantially less time than hedge funds, and there’s much that remains to be done with this exciting new tool.

Derivatives are overwhelmingly used by institutions and large businesses that deal with assets in the hundreds of millions or billions of dollars. But I’ve been hearing some stories about derivatives being used to help individual high-net-worth clients directly. I thought I’d share one with you…

An advanced planner I work with told me about a case of his in which he’s creating a derivative to help a client with a $50 million real estate portfolio fund an estate plan without selling off assets to do so. Creating a derivative based on the underlying value of his real estate could allow the client to create cash flow that he would use for the purposes of funding an insurance policy for estate taxes, thereby allowing him to maintain the integrity of his fixed assets for himself and for future generations. To make this even more appealing, the derivative can be unwound at a later date so the asset is eventually passed on to the next generation without any restriction at all.

While a firm that’s big in the derivatives market—such as JPMorgan Chase—may consider such a transaction small potatoes today, there are already rumblings that these kinds of solutions are scaling their way downward.

Today, an investment advisor’s common client is a person who’s in his 50s or 60s and has some liquid assets, but has much of his wealth in fixed or illiquid assets, such as private equity or real estate. The advisor deals primarily with the liquid assets with the expectation that he will work with future liquid assets as they free up. The advisor may also offer consulting services to facilitate a private equity or asset sale resulting in more liquid assets to manage. Advanced planning turns this model on its head. By helping your clients retain the integrity of their assets while creating cash flow for other purposes, including investment management, you may be able to serve your client best without having a vested interest in the size of their liquid assets. Instead, you can participate in the management of their total net worth.

Developing customized financial solutions may be the next big tool in the advanced planner’s arsenal. I’d love to hear your thoughts on the pros and cons of leveraging a derivative for your individual clients.

This entry was posted on Wednesday, April 18th, 2007 at 1:13 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.