Welcome to this new column in which I will provide readers with an insider’s view of how family offices manage their assets. As a graduate of economics, I have applied my knowledge analysing economic and financial trends and applying it to asset allocation and portfolio construction. I have benefitted from the experience of working in the tranquility of a bank’s research department, the pressurised environment of short term trading desks at investment banks and hedge funds and been CIO to two investment firms. I want to share those experiences by bringing my own perspectives on economic and financial market developments and what it means for asset allocation. The Investment lens is long term in nature because that is the focus of family offices.
Family Office is the term given to a team of people employed to manage the assets of wealthy families. The size of team and range of activities varies enormously, and their collective wealth has increased as a proportion of total wealth. This has made family offices an important part of the capital supply chain. The growth of family offices is occurring in both the developed and developing world with the latter registering the fastest growth rate reflecting the economic success of those economies over the last twenty years.
It is not possible to generalise about the modus operandi of family offices. However, there tends to be a general demarcation of investment aspirations and behaviour between family offices which have existed for several generations and those that have created their wealth recently. In the case of the older family offices the owners behave more like trustees than owners of the wealth whereas the latter act as owners of wealth. The distinction is important as trustees tend to have a more cautious approach to investing than owners of capital. The reason for this difference in behaviour is that newly created wealth will often be the result of an entrepreneurial activity and the owner will be more familiar with business risk than financial market risk. Older family offices will have established a team of investment professionals accustomed to investing in financial markets.
Family offices are engaged in all aspects of the global capital markets, but an interesting aspect is their involvement in the alternative investment segment of the capital markets. Alternative investments are assets outside the investment universe equities and bonds. Alternative assets include private equity, private credit, real estate, commodities and hedge funds.
The implementation of these strategies will often be done by third party managers although some larger family offices will employ specialists to execute the desired strategy. The employment of a broad array of investment strategies, also known as a multi-asset strategy, paves the way for attaining more stable investment returns which accords with the aim of many family offices of preserving wealth in real terms rather than a get rich strategy. The diversified strategy, however, enables family offices to be involved in private equity, one of the highest risk but highest return asset classes.
The long investment time horizon makes family offices unique because they tend to think in generations rather than a retirement age or a single lifetime. This does not mean short term investment is unimportant, far from it, but it does mean that their willingness, and financial ability, to accept market volatility is much greater than other investor types.
The major challenge today for asset allocators is the price of financial assets. The decade long period of low interest rates, quantitative easing and below trend economic growth has pushed up the price equites and bonds to historically high levels. Even for long term investors, the purchase price of an asset is often the prime determinant of the eventual return on capital. With both asset classes expensive, having a conventional balanced portfolio split between bonds and equities, so that losses in one asset class tend to be offset by gains in the other, is unlikely to be a successful strategy this time around. With both equities and bonds unattractive only cash holdings or very short duration bonds can offer protection in the event of a downward correction in both equity and bond markets. This is not an overly attractive strategy given that the return on cash is zero in most cases.
Refining the equity strategy to invest in the high growth emerging markets and focussing developed market exposure on value as opposed to growth equity might blunt negative returns when markets have a down draft. Emerging markets used to be considered a higher risk than developed markets but due to favourable economic policies and improved regulation this is no longer necessarily the case. Additionally, many of the developed economies, most notably the United States, have been increasing their debt levels both in absolute terms and relative to the size of their economy and this is a concern.
Investing in value stocks, which are shares considered to be cheap relative to their fundamentals such as earnings and cash flow, is also considered to be a lower risk investment strategy. However, value stocks have under-performed growth stocks for many years. Growth stocks are companies that offer strong earnings growth potential. The fact that value has under-performed for so long suggests that the investment pendulum might swing back to favour value stocks, especially in an environment where equity prices are high.
For capital preservation strategies, though, families have been pursuing alternative strategies in the alternative asset classes Collectively these are known as multi-strategies and the notion is that each asset class has its own distinct pattern of behaviour that is completely un-related to the other asset classes. In general, this behaviour of uncorrelated returns holds true but in the Great Financial Crisis of 2008 this did not apply. These investment strategies also tend to be illiquid, which means the assets cannot be sold quickly.
We will discuss the merits of these various strategies over time but there is one strategy that is quite popular now with family offices and that is venture capital and direct investing. We are in an era of technological disruption due to the advancement of digital technology. Disruption has always happened, that is how economic development occurs. We are used to seeing the disruption in the manufacturing sector. But now there is disruption in the service sector and there are hosts of new companies emerging threatening well established companies. Family offices have become very engaged in the financing of early stage companies where the initial capital outlay is quite small. It is possible that the family has direct business experience of the company they are investing in and they can bring their experience and knowledge to the management. Access to this type of investing is either through third party venture capital funds. However, a more recent trend is for family offices to invest directly into companies either on their own or with other partners. For early stage companies this has become an important source of capital.
The high valuation of public markets and the changing economic environment of falling interest rates to rising rates which will induce more volatility in the markets, is encouraging capital to flow into the private markets.
