Even in low-rate era, wealthy investors earn 3 times more yield than average, researchers find

Wealthy investors earn higher yield on their fixed-income portfolios, which are riskier than average, new academic research found. This discrepancy betweenrich and average investors means that financial advisors are working harder to find opportunities for their mass-affluent clients to earn more on their investments.

“Rich individuals earn much more of their interest income in higher-yielding forms and have much greater exposure to credit risk,” wrote study authors Matthew Smith, of the U.S. Treasury; Owen Zidar, of Princeton; and Eric Zwick, of the University of Chicago Booth School. “Consequently, in recent years, the interest rate on fixed income at the top is approximately three times higher than the average.”

The National Bureau of Economic Research working paper, “Top Wealth in America: New Estimates and Implications for Taxing the Rich,” quantifies the conventional wisdom that advisors have long known: the wealthier the client, the more they are likely to stomach the additional risk required to invest in higher-yielding securities and the more access they have to the types of opportunities, especially private deals, that garner these yields.

“As you go up the wealth distribution, you have much more exposure to these funds that are higher yielding and take more risk,” said Zidar, a professor of economics and public affairs. He cites the example of former Hewlett-Packard CEO Carly Fiorina, whose finances became a matter of public record when she ran for president in 2016. As a well-paid California tech executive, Fiorina would have had plenty of access to investments that are harder to get into for investors with less money or fewer connections. So it wasn’t surprising that Fiorina would disclose that she held mezzanine debt in Goldman Sachs when she released her tax returns during the campaign.

Fixed income isn’t a large part of wealthy investors’ portfolios, but it “varies across the life cycle,” Zidar said. The top 1% of investors, the study found, held, on average, a quarter of their portfolios in each of fixed income, public equities, private companies and real estate. That’s below the level that the typical 60-40 portfolio would suggest.

Daniel Greenwald, a professor of Finance at MIT’s Sloan School of Management, has another take on how and why wealthier individuals have had better returns on their investments since the 1980s. A paper he co-authored with Matteo Leombroni and Hanno N. Lustig of Stanford and Stijn Van Nieuwerburgh of Columbia looks at the question of how interest rates, which have been falling overall for the last four decades, affect asset prices and wealth inequality.

In the study, “Financial and Total Wealth Inequality with Declining Interest Rates,” Greenwald and his co-authors found that households tend to be exposed to interest rates differently, based on the type of assets they own. Wealthier households have assets with longer duration, like stocks and private companies, so they’re more exposed to interest rates. This means that when rates go down, rich investors’ assets tend to get more valuable, he said. But when rates rise, the portfolios of less-wealthy individuals, which tend to include bank deposits, mortgage debt or other lower-duration assets, would be likely to go up. And that’s what might happen as the Fed pushes rates higher starting in 2022, as the central bank has announced it will do.

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“We believe that at least part of the high returns the wealthy have received may have been dependent on an environment of falling interest rates,” Greenwald said. “As a result, these unusually high returns the wealthy have received, the returns they receive in the future may not be as high.”

Investment analysts agree that, in addition to rates going up, the rich-getting-richer phenomenon has a lot to do with markets rising — which itself is partially due to the lower rates, which drive up asset prices.

“We have to be careful not to confuse genius with a bull market when you see that kind of trajectory,” said John Lynch, chief investment officer at Comerica Wealth Management.

What that means for advisors, Greenwald said, is that they should help their clients understand that, with rates set to rise, the days of runaway asset prices might be over: “The message I’d have would be to perhaps build into their expectations that past returns may not be indicative of future returns.”

For Mohit Desai, whose firm, Cranford, New Jersey-based MD Wealth Advisors, manages $47 million, ultra-low rates have meant that clients have a hard time finding yield. Institutional money market funds are often the best he can do for larger clients, with yields 70 to 80 basis points above regular retail money market funds. But those accounts aren’t available to smaller clients, who sometimes turn to an online bank, credit union or local bank branch to earn more on their cash.

“There is not much yield anywhere,” Desai said.

While “a less wealthy investor will do a diversified mutual fund or index fund as entry level and they won’t have that exposure to more sophisticated strategies,” Lynch said, higher net worth households can find themselves with private credit, taxable and high-yield muni bonds and other kinds of fixed income that yields more: “I do generally agree and see a lot of that happening now.”

As interest rates go up over time, Lynch anticipates investors will once again reach for hedge funds: “Non-correlated strategies will come back into favor in a rising rate environment, and that will enhance portfolio returns.”

But there’s no need to get fancy, he noted: “For the average investor, an S&P index fund is a good job, a total return bond fund can do a good job.”