In this two-part feature Angelo Robles, founder and chief executive of the Family Office Association, discusses the concept of “hyper-diversification”. The information is for educational purposes only and is not legal/tax/financial advice. The views within are the author’s but this publication is grateful for the right to share them.

One thing we have learned since the global financial crisis that began in 2008 is that no institution - or country - is too big to fail, in spite of the Geithner doctrine. What many of us may not have accepted yet is what that could mean for many a family’s fortunes.

Political upheaval (think Iran and Egypt), financial mismanagement (Lehman Brothers and AIG), scams (Bernie Madoff and MF Global), and even extreme weather (the 2011 Japan tsunami and Hurricane Sandy in 2012) can affect the safety and accessibility of investors’ assets.

In a worst-case scenario, it may be a matter of if, not when, investors can reclaim what they own. If a nation were to go under politically, any assets held within – from cash to real assets such as jewelry, art and coins – would be at risk.

This article describes three such risks – ownership, margin and segregation – and explores several critical solutions. By following these solutions, wealthy families will truly become global citizens and greatly reduce their fortune’s exposure to these risks.

Ownership risk

When clients purchase a block of stock from one of the large wirehouses, book entry is actually held in “street name” (the wirehouse’s name), not the client's. Computerization of the stock market and global capital markets have allowed financial institutions to move toward an electronic bookkeeping format. These wirehouses keep meticulous internal ledger entry records, which list ownership for each batch of securities (how else would proxy-voting occur?). However, issuing corporations see only the street holder name. As far as Google is concerned, for example, the wirehouse is the listed holder of these shares that individuals purchase through their brokers.

The lack of physical certificates can make it difficult to prove who owns an investor’s shares. For instance, the Depository Trust & Clearing Corporation, one of the largest companies that tracks stock ownership, saw its 10,000-square-foot underground vault where it stores its records immersed after Hurricane Sandy flooded its lower Manhattan offices on, ironically, Water Street.

The majority of the $1.7 quadrillion in trades the DTCC processed in 2011 were registered electronically, but the 1.6 million paper stock certificates (down from 8 million in 2000 and 32 million in 1990) were still sitting in DTCC’s vault at the time of the storm. These transactions were electronically recorded, along with images of all bearer stocks and bonds, but the company estimates it will take months to restore or replace the damaged certificates.

Potential ways to avoid this problem include:

• Take physical custody of stock certificates. Few investors who purchase shares even request paper certificates. The $500 or more that many brokers charge for a physical certificate undoubtedly dissuades most investors from requesting paper, especially for actively managed portfolios. As of 2010, more than 420 of 7,000 public companies, including Visa, Intel, Sears, Chevron, Tiffany and Tupperware, no longer print stock certificates at all.

It is possible to get paper certificates for free (from those companies that still issue them), but it requires time. Investors first must have their brokerage firms register shares directly in their name. Then the stockholder needs to contact the transfer agent and request the paper certificate. To do this for every company’s shares an investor owns would be time consuming. Therefore, investors would only jump through these hoops for shares they consider to represent a long-term investment outlook, owning the company instead of temporarily investing in it in the pursuit of alpha.

Of course, investors who take possession of their stock certificates still must keep them safe from fires, floods, theft or simply from getting lost. Therefore, it is wise to keep them in sealed, waterproof containers and if possible in more than one location. Those families already holding precious metal bullion in their respective fire and waterproof vaults in each of the family’s homes should consider keeping a small portion of their securities diversified into each of these private locations, in addition to a portion in public safety deposit boxes at key banks in different countries such as the US, Canada, Switzerland and Singapore, where existing relationships exist.

• Avoid middle men. Look towards making future long-term ownership investments directly through the issuer, not through brokerage firms or banks. Even if these companies no longer print stock certificates, at least purchased securities will be listed in the owner’s name. This only makes sense for very wealthy clients who have the ability—such as through their family office - to manage the administrative requirements that will result.

• Go private. Large investors can often purchase significant blocks of stock at negotiated prices (sometimes up to 5 per cent to 25 per cent discount to current market price) via Private Investments into Public Entities (PIPES).

It is important to note, however, that this is a sophisticated transaction and, generally, the higher the discount the less liquid the stock. Small and medium-size public companies that have difficulty raising funds during tight capital markets can sell common, preferred or convertible securities directly to private investors outside the stock exchanges. The best bets are those companies fitting the investment in the long-term hold profile of the private family. Sometimes even the largest blue chips with global footprints are open to such PIPE transactions, such as Goldman Sachs did with Warren Buffet in the preferred deal after the 2008 event.

Few advisors will help individual families do a PIPE given that assets would be held away, but those with deeper and strong relationships with the family will deliver the firm’s capabilities and together with the family office CIO, a good due diligence and exploratory look can be achieved.

Further, with this initial process under way, the family office CIO can further shop this out at several other investment banks that put such financings together, and have them compete for the business. Once up to speed, CIOs, especially those who are Chartered Financial Analysts, can run the numbers and implement such investments themselves for future PIPE opportunities.

Margin Risk

Wirehouses are legally permitted to use shares owned by clients as collateral for other clients who want to implement option strategies, short a security or even buy on margin. This is also known as rehypothication. Investors who hold securities are exposed to having their stock held in street name at any of the “too big to fail” banks, and thus should at least request their advisors remove the rehoypethecation capabilities in those accounts where they hold long-term ownership and are not using options or margin trades for their own strategies.

The purpose is chiefly to limit large institutions’ tentacular reach into clients’ holdings and prevent them from borrowing against their shares. Keeping separate accounts – one with margin and the rest without - maximizes safety without limiting transactional capabilities or strategic alpha-seeking strategies.

The risk is that in the event of a Black Swan event or the collapse of the brokerage firm or bank, all private client assets may be frozen. This occurred with the collapse of Lehman Brothers in 2008. Unwinding all the rehypothecated securities and then separating the custodian and ownership for each client, share by share, company by company, prevented individuals from having immediate access to their money, shares or accounts. If investors’ money or assets are not listed in their name, they are exposed.

One immediate precautionary action to take is to call each broker and have them remove rehypothecation/margin capabilities from those accounts that do not require them, at each of the institutions where accounts are held.