Investment

Family offices should forget pooled funds – they can’t be trusted

The Financial Conduct Authority, the UK regulator, has provided family offices with proof, if proof were needed, that pooled funds cannot be trusted. 

In a new survey on the value for money offered by funds, the FCA says managers are failing to implement the reforms it suggested five years ago. 

Family offices are moving on from spreadsheets, and using advanced analytics to calculate risk-adjusted returns

Clients are not getting fee discounts when funds achieve scale. Managers tell clients they are offering value, even when they are lagging the index. They have negotiated cost cuts with service providers, but remain reluctant to reduce their own fees. Instead of  setting themselves precise targets, managers talk of their aspirations which typically involves “long-term capital growth.”

Family offices want to be price makers, rather than price takers. They fail to see why they should invest on these terms. And this is not a UK domestic problem. 

US regulators have been grappling with cost issues, ever since the Investment Company Act of 1940, which said high charges for low returns amounted to a breach of duty.

In 1982, Irving Gartenberg won a US court case against Merrill Lynch Asset Management which said managers could be sued by setting fees “so disproportionately large, it bears no reasonable relationship to the services rendered and could not have been the product of arm’s length bargaining.”

The definition was wide and the Gartenberg ruling was upheld by the Supreme Court in 2010. 

And the problems continue. In November 2019, the SEC Office of Compliance Inspections and Examinations (OCIE) said fund directors were failing to request data, such as underlying profitability, to evaluate client agreements.

In November 2020, OCIE identified compliance deficiencies, as a result of the failure of advisers to devote sufficient technology, staff and training to programmes. It said they were failing to hire sufficient compliance staff to take care of growth and complexity at a senior level.

Alternative investments have also brought disappointment. Back in 2004, Man Group was charging 5%, plus a performance fee of 30%, for its guaranteed hedge funds. Basic hedge fund fees are nearer 2% and 20%, but performance has been dropping for years due to easy-money policies from the central banks, coupled with woeful client communications.

Private equity and venture capital have been all the rage, given that low interest rates have been boosting capital returns. But family offices are moving on from spreadsheets, and using advanced analytics to calculate risk-adjusted returns. Consultants say they are getting increasingly concerned at the way costs and fees have been taking a huge bite out of their returns.  We could see some fallout quite soon. 

Retired consultant Richard Ennis recently analysed returns from US educational endowments over the 11 years to June 2019, and found they were trounced by index trackers after fees costs.

A packaged solution marketed to family offices by the late Bernard Madoff was later found to be fraudulent.  Family offices that invested in hedge funds prior to the 2008 crisis were exposed to their illiquid investments when markets crashed.

GAM Investments, once marketed to Europe’s most wealthy, suffered badly after 2018 as it emerged that its core fixed-income fund had a massive exposure to debt issued by Greensill Capital, now insolvent.

The least that family offices can expect from pooled funds is transparency in difficult situations. According to one adviser: “Family office interest is always a function of transparency, alignment of interests between manager and unitholders, and operating costs. Those aspects are aligned with the fund’s overall governance structure. The greater the opacity, the less the investor interest.”

For many, the use of easily-traded Exchange-Traded Funds has become core, often used in separate-managed accounts, where family offices know exactly what is going on. 

Niche products can appeal to family offices. According to one consultant:  “The international small-cap and emerging markets are sectors where active makes a lot of sense. The sheer number of securities makes indexing less optimal, not to mention the potential added-value of due diligence at the security level.” 

But lawyer Moshe Strugano says asset managers need to have a precise understanding of needs and tolerances: “Family businesses are a completely different business from the business they come from.”

Advice can work. But principals see no reason to jump straight into a pooled fund because there is generally a newer, or better, alternative round the corner, as Greg Barasia of New Vermont Capital points out.

It costs 1.2% a year to maintain a family office, according to UBS, so paying additional fees to pooled funds does not often make sense.

Barasia recalls a story told years ago by Fabrice Grinda, founder of a tech-driven auction site, when he approached Bernard Arnault for funding.

Arnault said: “You have a unique opportunity to create eBay for the rest of the world. We will give you the human, financial and industrial resources to guarantee your success. In order to show you our commitment to your project, we will offer you twice the valuation and twice the investment that you have received to date. However, to show to the world that this is a strategic project for us we want 51% of your company.”

Family offices like to be in control.  They like to strike deals on their terms. So why should they pay standard fees to others to call the shots?

 

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