Family offices should intensify their hedging strategies, says top advisor


Given that entrepreneurs pay close attention to the corporate bottom line to underpin their wealth Mike Faulkner is surprised that family offices do not hedge their operations more thoroughly.

Building on his experiences sorting out pension schemes – a bit of a UK speciality – he is negotiating a hedging service with ten US family offices. He believes they could hedge four operational exposures relating to their portfolios, businesses, objectives and charitable donations.  

If you take a ball, and drop it, you can easily see its direction of travel, due to the force of gravity.  When you apply this to markets, you can see their early direction of travel. But you can’t see their destination

The procedure would limit losses, and reassures family offices that it is safe to be fully invested.

Faulkner is viewed as one of the UK’s brighter investment consultants. He is chief executive of River & Mercantile, which supervises assets worth £34 billion ($44.3 billion).

He has a background in mathematics and mechanical engineering and uses it to develop funding solutions. Along the way, stressing the importance of teamwork, assesses market trends for asset allocation and hedging purposes.

Everything depends on taking a correct view on where the market is headed over time. He says: “If you take a ball, and drop it, you can easily see its direction of travel, due to the force of gravity.  When you apply this to markets, you can see their early direction of travel. But you can’t see their destination. You need to ally a trend with the reason why it existed in the first place, while taking account of the forces acting on it, which are often economic.”

Not all together easy, but Faulkner’s team spends a great deal of time finessing data and pricing trends. This can lead to a few sharp swerves: “I retain the right to change my mind,” he says. But trends can remain intact longer than you might expect, and Faulkner believes investors often buy and sell their positions too quickly.

In September, Faulkner decided markets were heading for a downturn and cut back his risk positions. During the final quarter, high yield spreads over US Treasuries rocketed from 326 to 550 basis points, tightening credit positions, hitting equities and producing a terrible quarter for asset managers.

Faulkner soon decided this sharp rise in corporate funding costs could not be tolerated by the authorities. He swerved to a more bullish tack in January, before the US Federal Reserve carried out a monetary U-turn and stopped tightening.

Faulkner sets out to work with family office portfolios, with a view to reducing downside risks to no greater than 10%, capable of generating returns of 6% to 8%.

“Family offices want to generate a sensible return, without nasty shocks.  We use tail hedging to achieve this, but we don’t use it when the wind is behind the market.” Derivatives and physical assets are employed

He can probably get there, given that R&M’s Total Investment Governance Solution for pension schemes has produced an annualised 9.6% since inception in January 2004, or 2.2 percentage points over its benchmark.

Faulkner believes interest rates are set to stay low throughout 2019. His research confirms the banks have stabilised, with much of their debt transferred on an unlevered basis to institutional investors. Europe and Japan are also operating easy money policies.

“We are also going to see some great days for emerging markets. China is stimulating its economy, and it’s going to keep stimulating until it works.” He’s not flustered by the US trade war: “It’s only a small part of GDP.”

But he doesn’t deny that cheap money has distorted the market. “Low rates have taken the edge off diversification. You can do just as well mitigating risks through a hedging programme.”   He is concerned about the way private equity deals have been financed, but that’s a worry for the future.

Putting aside portfolio returns, Faulkner is talking to family offices on ways to hedge the risks to which their business interests are exposed. “Family offices often have punchy positions in illiquid assets, which leave them exposed.”

He is talking to a number of Texan families, where Faulkner lives part of the year, and found that a lot of them are exposed to the energy sector, as well as companies that service it. “You need something to hedge that out during a downturn and this involves sectors which benefit from lower oil prices, like energy distribution or transport. You can use energy derivatives or physical investments, where you can hedge away market risk.”

He says family offices can use his advice to achieve their objectives. “Say you’re a property developer. You might take the view that you want to put your cash to work by investing in hedge funds. But that would be a bad idea during a crisis, if they are closed due to  redemptions, and you can’t realise cash to take advantage of distressed real estate prices.”

Faulkner says there are other ways of remaining liquid, through short-dated bonds, Treasuries and quality stocks. Not exacting, but a safer way to achieve operational targets.

Faulkner suggests that family offices can also change the way they treat charitable contributions. “If they want to make regular donations, we suggest that they amount to an emotional liability, which can be funded in just the same way as a pension scheme,” he says.

“This means you can look for opportunities to lock in credit at a high yield, when the market falls.”

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