The old adage about the three phases of investing in an asset is very pertinent to how family offices think of themselves when it comes to investing. Briefly, the adage goes something like this - the sophisticated investor buys into the asset early and makes the most money, then institutional investors pile in and make beta-like returns, followed lastly by the retail investor, who gets burnt and loses money. The cycle repeats itself with every new asset class.
Whether that happens a lot of the time, or rarely, family offices shouldn’t exclude themselves from learning a thing, or two about investing from the institutional side. With that in mind, here’s five points, adapted from a recent McKinsey report on new thinking on maximizing returns in the institutional investment world. Where necessary, Family Capital has adapted some of the points to be more pertinent to family offices.
Know your liabilities - the family
The McKinsey report reckons that institutional managers need to know more about their liabilities, rather than their assets. OK, the liabilities for a family office is usually just one family and not thousands of pensioners. But the point still has its relevance for family offices. Rather than just consider the annual performance of the assets, get to know more about the needs of the family, and, indeed, each family member who is a beneficiary of the family office. That can help to serve the family office with more suitable products, like target-date funds. Not all family members are likely to think in the same time horizon when it comes to returns. Some might be geared more to long-term returns, others more short term. Different target-date investments can help to keep all family members happy when it comes to their expectations of returns.
Risk management of illiquid assets
The big shift from liquid to illiquid assets is a phenomenon that’s been well documented by Family Capital. But what has been less well documented is the importance of the risk management of those assets. Increasingly, traditional risk management strategies are unlikely to be enough for these assets, so family offices are going to have to come up with some new thinking on this. Stress testing of assets like banks do might be one of the ways forward, and looking at the probability of capital loss of big investments, could be another. Of course, implementing new strategies has a costs attached to them - and that brings up a whole other set of problems, like whether to outsource any new risk management strategies adopted, or to do them in house.
Regular changes to strategic asset allocation
Numerous studies show that around 90% of variation in returns are attributed to asset allocation decisions. But, despite this, most asset managers, and this includes family offices, spend at least 80% of their time on seeking alpha. The importance of strategic asset allocation has been known for some time, but needs to be practiced more by all investors, even family offices. As the McKinsey report says, hitting ‘repeat’ on strategic asset allocation on an annual basis might not be the smartest strategy: “...the payoff from getting strategic asset allocation right is worth a decade of good deal-making to create alpha at the margin.” Even extreme allocation, where, for example, 20% of a portfolio is allocated to cash, is better than no, or little change to strategic asset allocation over one, or more years.
Move the portfolio goalpost
Too many investors use the same set of definitions when seeking returns in a particularly asset class. Many seek similar returns in private equity, hedge funds and in other asset classes. This, as the McKinsey report points out, can lead to “winner’s curse” - asset buyers paying too much for the deal, as everyone looks to achieve the same returns. By approaching investment more from a thematic perspective, investors can move away from duplicating what most other investors are trying to achieve.
Emphasize a top down approach
The McKinsey report says that institutional investors are paying more attention to top-down economic scenarios when it comes to asset allocation. This approach, says the report, should help managers to better argue the need to change strategic asset allocation on a more regular basis to maximize returns. After all, macro-economic conditions change regularly and asset allocation should probably better reflect those changes.