Principals and family office investment professionals spend significant time and attention on investment decisionmaking. Yet, family offices often don’t achieve their desired investment outcomes. Failing to achieve long-term target returns and required cash flows or experiencing unexpected portfolio volatility may result from the absence of robust investment processes and/or investment experience.
Increasingly, many family offices manage large, complex, multi-asset portfolios (trust, foundation or personal) that span global markets. These often include direct investments in real estate, venture capital and private equity. Yet, unlike some of their institutional counterparts, family offices and their foundations often lack self-awareness as to the strengths and weaknesses of their investment process and staffing.
Regrettably, many family offices only take stock of their investing skills after suffering portfolio losses. While family offices will monitor their portfolios and measure individual risk factors, including geographic, currency, sector or counter-party exposures, the family office staff or its principals typically don’t evaluate “competency risk.” What is competency risk? It’s a fundamental mismatch between the family principal’s expectations for the portfolio and the investment process, skill and experience of the family office available to consistently satisfy those expectations.
Two Key Questions
Assessing the readiness and adequacy of a family office’s investment capabilities begins by addressing two fundamental questions:
Investment process—Does the family office have a rigorous and repeatable investment process, a well articulated and periodically reviewed investment strategy and a regular assessment of results based on pre-defined benchmarks?
Resource alignment—Does the family office have the required in-house and/or external investment experience, people, content and technology to properly manage the amount, type and complexity of assets under management (AUM)?
Five Common Elements
A consistent internal or outsourced investment process has five common elements:
1. An investment policy statement (IPS) that delineates the specific objectives, timeframes and benchmarks for the family’s portfolio;
2. An asset allocation program that reflects the true risk tolerance of the family members;
3. Effective portfolio construction, based on rigorous investment research and analytics, and ongoing monitoring;
4. Periodic, in-depth performance reporting against benchmarks and goals; and
5. Risk management practices to manage downside risk and excessive volatility.
Auditing the family office to see how the process works in practice yields important information as to its ability to consistently deliver desired investment returns.
The IPS is the cornerstone document that defines the objectives of the family’s investment process; sets the parameters associated with investing, including limitations on individual positions and market exposures; delineates responsibility, authority and committee structure; specifies the frequency of portfolio rebalancing; and establishes standards for benchmarking performance. The IPS also specifies the roles and responsibilities for staff, asset managers, custodians and advisors.
The process of developing a family’s IPS represents a unique opportunity for family members, staff and core advisors to identify and discuss inputs. It should foster critical dialogue and be revisited at least annually to address market conditions, changes in family objectives and past experience managing the portfolio.
There’s a large body of academic work that confirms the central importance of asset allocation and its effect on portfolio returns and volatility.1 A sound asset allocation model is one that marries the investment attributes and estimated return scenarios of asset classes around the globe with the return, risk, liquidity and behavioral biases of the family, as delineated in the IPS.2 The output of the asset allocation process will express the optimal weightings for asset classes within a family’s portfolio, as well as the range of probable outcomes that fall within the risk parameters of a given portfolio. This approach involves four core elements:
1. Identifying the primary needs and preferences of the family;
2. Analyzing asset class returns under varied volatility, correlation and extreme downside risk assumptions;
3. Assembling a range of investment allocations across core asset classes3 and sub-classes; and
4. Exercising thoughtful judgment as to the optimal mix of assets, giving proper weight to the family’s true risk tolerance.
Effective asset allocation calls on sound quantitative skills and investment judgment and experience.
The development of an appropriate investment portfolio has two core elements: (1) rules associated with portfolio construction; and (2) manager (or portfolio content) selection.
The rules associated with portfolio construction establish minimum and maximum exposures by asset class and geography, rebalancing rules and timeframes and the degree to which tax and fee efficiency are primary elements of strategy implementation.
Manager selection is the means by which the portfolio is implemented. It begins with an assessment of whether passive indices or active management is preferable for each asset class/sub-class and/or geographic exposure of the portfolio. For example, the ability of an active manager to add alpha (excess return) after taxes and fees is a primary consideration. The use of alternative investment managers is also a key consideration for suitable investors, given the risks and long-term nature of these investments and their role in portfolio diversification.
The ability to construct and manage effective portfolios relies heavily on robust investment research, from individual manager research to macroeconomic analysis. Effective family offices develop external resources that allow this overwhelming amount of data to be accessed, synthesized and evaluated effectively. Often, these resources include investment advisory boards, consulting firms and private banks. The role of the family office is to carefully select these external resources and to oversee their application, consistent with the IPS being implemented. From their perspective, the goal is to achieve superior outcomes, regardless of where the content originates.
As investment portfolios have grown in complexity, size and diversity, performance reporting has taken center stage. Increasingly, family offices engage a more diverse range of asset managers based on their style, asset type or geographic focus. This makes it exponentially more difficult to integrate, analyze and report performance4 when all factors, from currency to infrequent asset valuations, are considered. Many turn to master bank custodians or consolidated reporting solutions to address the integration of tax-lot level account data, processing of corporate actions and report preparation. The best solutions provide the family office with performance data versus custom benchmarks for each asset class, asset manager and family branch and identify key portfolio characteristics and risk metrics.
Risk management begins with the identification of core risks that may impact the portfolio. These portfolio risks fall into two broad categories: (1) systematic or market-level risk; and (2) non-systematic or security-specific risk. Based on this analysis, the family office must define practices that measure and monitor these risks, as well as identify pre-defined risk mitigation strategies. For example, families with concentrated stock positions or large interest rate-sensitive liabilities will often turn to hedging strategies. Additional key areas of risk focus include:
• Exposure (factors that give rise to positive and negative returns);
• Counterparty or agency (concentration or absolute exposure to one or more firms that issue, manage, hold, transact or control assets5); and
• Illiquidity (the likelihood of being unable to access portfolio funds within one to two quarters, due largely to bankruptcy, lock-ups, side pocketing, extensions of fund life by general partners or unpredictable portfolio exits).
In many ways, competency risk is the least acknowledged and discussed risk in the family office practice. This is particularly true for offices that have complex, multi-asset portfolios and limited staff resources or investment experience. This may be further exacerbated by investments in hedge fund strategies or direct private equity and venture capital, which require even greater depth of experience and skill on the part of family office staff. The same can be said for executing complex capital markets transactions.
Family offices experience competency risk in different ways. At the extremes, some needlessly delegate comprehension of investment strategies and products to third parties, believing the family’s interests will be well served. Others adhere to the belief that there are few limits to their ability to manage investment assets, skill and experience notwithstanding.
The best way to understand and mitigate competency risk is via a thorough and candid assessment of the strengths and weaknesses of the family office resources (staff, technology, content and investment practices), relative to the scope of the investment demands being placed on them. For example, if a team is being asked to actively trade foreign exchange, quantitative factors (such as relative return and performance attribution) and qualitative factors (such as experience across a range of market and economic cycles) may be used as indicators of strength and weakness. Based on the outcome of this readiness assessment, competency gaps can be identified and filled internally or externally or investments avoided. Numerous external alternatives exist for family offices that wish to augment their research, investment, trading or manager- monitoring shortfalls.
Investment Process Inventory
Taking inventory of policies and practices and their effectiveness should be a periodic exercise. Some family offices will self-assess their capabilities, while others use consultants to assess operational effectiveness. Regardless of approach, answering the following questions is critical:
1. Are core investment processes present in the family office, and do these or other practices need to be in place, given our unique characteristics and changing needs?
2. Do we consistently implement practices?
3. How do our portfolio returns compare to benchmarks and peer group data?
4. Do we have the right resources (for example, people, experience, data and systems) to effectively carry out these processes consistently over a long term?
5. Does it make sense to augment or supplant these activities through outsourcing?
Build or Buy
Estimates from a 2008 study suggest that 25 percent to 35 percent6 of family offices acknowledge that they lack the necessary staffing and skills to properly manage their investments. A 2012 survey by Family Wealth Alliance found that 33 percent of family office respondents reported not having sufficient in-house resources to properly evaluate investment vehicles and strategies. Interestingly, family offices often report the highest levels of confidence in their skills at the peak of bull markets and the lowest after having suffered losses.
When it comes to management of wealth, family offices generally face the question of whether to build resources (for example, people, technology and research capabilities) to meet the demands of their investments or to limit their investing, based on their available resources or skills. Problems often occur when there’s a fundamental mismatch in two areas:
• Too few resources or too many resources and costs. Family offices are prone to both extremes, attempting to invest with insufficient resources, as well as over-paying relative to their investment returns and risk exposure, particularly when both direct costs (staff) and indirect costs (for example, manager fees, carried interest and custody fees) are factored in.
• Insufficient staff skill and experience to manage large, complex, multi-asset portfolios. Family offices can be costly endeavors, and principals may be tempted to overreach in an effort to economize. Much like any business, the family office must determine where and how it will spend to achieve a competitive advantage. Mediocrity in investment staffing rarely produces desired results.
Periodically assessing the cost/benefits and investment readiness of an in-house investment organization invariably leads to the question of “build or buy” (or a hybrid involving elements of both). The factors influencing this decision include the: inability to hire and retain experienced investment talent; rising costs of staffing; inability to achieve scale efficiencies (too many resources to support too few AUMs); difficulty accessing best-of-breed asset managers; complexity of new alternative investments; portfolio losses; lack of confidence in staff; behavioral traps; and uncertainty concerning the investment climate.
Selection of an Advisor
Families desire to create long-term operating practices that can sustain family wealth over time, across many generations and through changes in family office staffing, regardless of who’s running the family office.
Family offices should choose an advisor that:
1. Truly embraces an open architecture with regard to screening and recommending asset managers and doesn’t favor in-house products and funds. Exceptions to this rule may include cash, core fixed- income portfolios, passive investments or when the advisor also acts as discretionary asset manager.
2. Is fully transparent with regard to all fees and conflicts.
3. Has broad experience and substantial staff in such areas as asset allocation, manager research and monitoring, financial reporting and risk monitoring/management.
4. Possesses the technical capacity to monitor and quarterback all other asset managers or sub-advisors.
5. Has a central focus on the unique needs of family offices that’s not simply a byproduct of advising large endowments and foundations or smaller AUM clients.
6. Possesses and offers technology solutions to the family office, as well as provides training and education for family members and staff.
7. Can effectively support the investment decision-making practices and culture of the family office.
Third-Party Provider Models
While many outsourcing models and providers exist, most often, family offices select from a range of consulting firms, private banks, brokerage houses, trust companies and multi-family offices (MFOs) to find the solution that makes sense for them. The basic provider models include:
Quarterback. The advisor analyzes and monitors all assets, regardless of which firm is managing the underlying accounts or funds. Private banks, certain brokerage firms, trust companies and select MFOs are often the principal providers.
Benefits: The family has a comprehensive asset allocation, research, monitoring, reporting and risk framework. This model is often beneficial to families that don’t want to hire in-house investment staff and want to invest with a variety of firms.
Drawbacks: Closed architecture firms (that is, those who recommend their own funds) may pose potential conflicts; skill and experience may vary greatly by firm.
Investment consultant. The advisor focuses largely on manager research and portfolio construction based on a defined universe of manager coverage (core, alternative and specialty funds). Consultants may be small boutique firms or large advisors that serve endowments, foundations, private clients and corporations.
Benefits: Access to a broad range of manager research, global reach, institutional quality and well-resourced teams. A family can isolate manager research and selection from all other aspects of asset allocation modeling; reporting and risk management can be provided by other firms or handled in-house.
Drawbacks: The large consulting firms often cover larger funds to be able to provide access to their sizable client base, generally higher fees, potentially slow reaction to changing market conditions and potential challenges scaling to the personal requirements of a family.
Manager of managers. An advisor assembles custom portfolios (for example, asset managers, funds and separate accounts), often in strategies that are difficult to research, access or monitor without the benefits of a larger team and purchasing scale. Assets may be managed on a discretionary basis or advised. A variation on this approach is a fund of funds, which may represent a predefined pool of funds. Banks, private banks, select mutual fund companies, brokerage houses and MFOs are the primary providers in this area.
Benefits: A family office can hire advisory firms with specialized skills and depth in specific asset areas to create one or more custom portfolios.
Drawbacks: Often higher fees, limited fund selection, potential for conflicts and liquidity management issues.
Which family offices most often benefit from outsourcing investment processes and advice?7 Outsourcing works well for families that have well-defined governance and decision-making practices, regardless of the presence of in-house investment staff. Some families choose to maintain in-house investment teams of varying sizes and skills to assist in processing advisor recommendations, to undertake specialized investments not offered by the advisor (such as direct venture capital or real estate investing) or to augment the advisor team in areas of specialized research. Others scale back staffing or see no need to incur the cost of investment professionals.
The benefits of outsourcing investment processes often include access to:
1. A wide range of investment resources (often around the world), such as sector specialists, country specialists, economists, manager research and due diligence teams.
2. A diverse range of asset managers and sophisticated ideas.
3. Technology, content and tools that wouldn’t be cost effective if sourced directly by the family office.
4. The ability to augment specific content, skill and experience gaps in the family office.
Much of the value provided by such an advisor is in the form of the investment discipline, ideas and focus the advisor brings to the investment process. Effective advisors will listen, but push back when actions deviate from sound investment practices or the stated policy parameters agreed to with the family.
The problems associated with outsourcing that are often cited include: hiring the wrong advisory firm based on the unique needs of the family office; poor portfolio results (particularly in 2008); lack of clarity around potential or actual fee conflicts; necessity to “piggy-back” the research coverage of the firm; and perceived loss of control.
—The views expressed herein are for informational purposes only and are those of the author(s) and do not necessarily reflect the views of Citigroup Inc. Each investor should carefully review the risk before investing. Individual experience will vary.
1. For a survey of current practices, see Frank Fabozzi, ed. and Harry Markowitz, The Theory and Practice of Investment Management (2011) and Roger Gibson, Asset Allocation: Balancing Financial Risk (2013).
2. This should include: discussions regarding liquidity, total/after tax return expectations, wealth preservation/income/growth trade-offs, volatility and tolerance for loss.
3. Institutions, advisors and family offices use a wide range of asset classes and sub-class definitions.
4. As well as investment policy statement compliance, performance attribution and deviations from target asset allocations.
5. Much has been written recently on counter-party risk in largely unregulated swap markets.
6. The New Gatekeepers: Winning Business Models for Investments Outsourcing, Casey, Quirk & Associates (December 2008), www.caseyquirk.com/pdf/The_New_Gatekeepers_December_2008.pdf.
7. For more information on outsourcing, see Mark Wickersham, “Single- and Multi-Family Office Outsourcing,” Trusts & Estates (February 2013), at p. 37.