Family Office: Investing in the Secondary Market, Six Key Points to Consider

Since the beginning of this year, influenced by the factors of macroeconomic uncertainty, some family offices (referred to as “family offices”) have increased their allocation ratio in the secondary market.

So, what are the key points that family offices should pay attention to when allocating in the secondary market?

At the end of the last century, in the field of finance, there was a well-known study. After a team of scholars conducted an attribution analysis on a set of portfolios, they found that Strategic Asset Allocation is the most significant factor affecting returns, with more than 90% of the returns attributable to strategic asset allocation.

The investment strategy of a family office is often strategically allocated based on the needs of the family and the external market environment.

When constructing an investment strategy, it is common for the family office CIO (Chief Information Officer, a senior official responsible for all areas of a company’s information technology and systems) to have in-depth communication with family members. After obtaining key internal information and a deep understanding of the family, and with a sufficient grasp of the market, the final investment strategy is constructed.

The investment strategy needs to consider the following three core dimensions:

1. Diversified allocation for each industry, such as how much to invest in the financial industry, how much in the technology industry, etc.
2. Geographical allocation of assets, such as how much of the assets are domestic and how much are foreign, with further breakdowns of foreign assets into how much is invested in North America, Europe, emerging markets, etc.
3. Currency, different geographical investments correspond to different currencies.

Currently, there are some existing investment models and asset allocations on the market. For example, family offices can refer to the asset allocation models of investment banks and consider how to allocate assets in a more balanced, reasonable, and diversified manner based on their own circumstances.

Constructing investment strategies

After formulating a strategic investment strategy, the family office also needs to make tactical adjustments to its positions based on changes in the market and within the family.

For example, after the outbreak of the Russo-Ukrainian War this year, the family office’s Chief Investment Officer (CIO) needs to analyze the macro market and consider whether the European financial sector will be impacted by the energy crisis and whether the family office should reduce its positions in that sector.

It is worth noting that family office CIOs usually do not engage in extremely radical investment operations. Once the asset allocation framework is established, only minor adjustments should be made to the asset portfolio during the investment process, and there should be no aggressive, large-scale adjustments to the previously formulated strategic investment strategy.

Some families often compare the performance of the family office’s secondary market with the performance of some “stock gods” and “well-known funds” in the market, which can cause a lot of trouble in the communication process between the family office CIO and the family. Therefore, it is very important to clarify the expected returns at the early stage of the family office establishment.

For ultra-rich families, when establishing the return target of the secondary market, it should be considered from two major dimensions:

First, the macro expectation of asset management within the family is an important factor affecting the expected returns of the family office’s secondary market.

For example, suppose a family is very active in the primary market, investing in many emerging industries and early-stage projects, and taking on higher investment risks. Therefore, in the allocation of the remaining funds, they should seek relatively safe and stable investments. In this case, the family’s expectations for returns from the secondary market should not be too high.

II. External Macro Market, that is, different historical periods, different regions, and market volatility will also affect the expected investment returns of the family office.

For example, for a family whose industry is dispersed in Europe, when investing in the secondary market in Europe, they should have an understanding of the local market. Over the past few decades, the performance of the European secondary market has been poor and not as strong as the U.S. stock market. This is also closely related to the European economy.

The family office CIO should synthesize the family’s internal expectations for returns in the secondary market along with the external macro environment, ensuring that the investment return targets are within a relatively reasonable range.

To establish investment income goals

For a family, in the vast majority of cases, the risk tolerance is within a certain range. For the family office CIO, it is absolutely not allowed to let the family bear investment risks beyond its risk tolerance.

When establishing risk tolerance, the family office should consider from two major aspects:

First, clarify the daily fluctuation range of the family office, which the family will be relatively comfortable with.

Generally speaking, the daily fluctuation range that the family office can withstand is not the number that the family verbally states. The CIO needs to actively observe the family’s response after market fluctuations to truly understand the family’s risk tolerance. During this process, there will be a certain period of running-in between the family office and the family.

For example, even in the bullish U.S. stock market of 2021, the largest drop was 6% to 7%. During market fluctuations, the family office’s Chief Investment Officer (CIO) needs to observe the family’s performance, that is, whether the family is panicked and whether they put pressure on the CIO, in order to clarify the family’s investment mentality.

Secondly, the family office needs to communicate with the family in advance about the family’s risk tolerance under extreme circumstances.

The secondary market will inevitably encounter some extreme situations. For example, in the first half of this year, the U.S. stock market fell by more than 20%, resulting in extremely high market volatility. The family office needs to communicate clearly with the family about their risk tolerance in extreme situations and maintain communication with the family during extreme times.

“Among them, investor education is very critical. The family office CIO needs to communicate clearly with the family in advance, under the long-term investment philosophy, that even in very poor periods, as long as the correct asset allocation is made, the returns will ultimately perform better over time.”

For family office CIOs, building a trusting relationship with the family is mainly achieved through two major ways:

First, helping the family establish the correct investment philosophy.

If a family has never allocated to the secondary market, the family office CIO must take time to help the family understand the characteristics of the secondary market and establish the correct investment philosophy.

Among them, for family offices facing the global market, reasonable diversification of investment risks is particularly important. Whether it is Buffett or Dalio, they did not become successful investors by speculating on individual stocks. In the long run, the risk of speculation on individual stocks is extremely high.

Clarify risk tolerance level

II. Upholding Long-termism

One of the significant challenges in the secondary market is the constant fluctuation in the net value of accounts. Regardless of whether it is the family office CIO or family members, the mindset will change when they see the fluctuation in the net value.

For families lacking investment experience, the emotional change in the face of high net value fluctuations is substantial, leading to questioning of professional managers. For family office CIOs, if the emotional ups and downs are too great in the face of market fluctuations, there will also be certain issues in investment operations.

Only by adhering to long-termism can family offices calm down and invest. For families, they should scientifically compare returns based on a half-year, one-year, and two-year cycle, instead of being overly concerned with the fluctuation of the net value of their accounts every day and every week.

For family offices that are initially trying to invest in the secondary market, the family office CIO should gradually help the family get used to the volatility of the secondary market. Subsequently, as the family’s investment in the secondary market increases, they can also better adapt to the changes in returns brought about by fluctuations.

From the perspective of asset managers, the volatility of the secondary market is reflected in the accounts on the same day. Therefore, communication between the top decision-maker of the family office and family members is very important.

During periods when the overall market performance is poor, for example, when the S&P 500 index has a cumulative decline of more than 20% in the first half of the year, assuming that the family office’s account has incurred a 16% loss, this figure has actually outperformed the overall macro market, but it is still a substantial loss on the books.

If communication between the family office and the family is not smooth, and the family’s understanding of the secondary market is not particularly profound, they will think that the family office’s risk control is not in place and there are certain problems with investment management, and they will not be able to accept a 16% loss on the books.

The CIO of a family office plays a crucial role in communicating with the family, and there are three key points to consider:

1. The CIO of a family office has the responsibility to guide or educate the family to deepen their understanding of the secondary market.
2. The CIO of a family office needs to maintain regular and ongoing communication with the family.

The secondary market is closely linked to macroeconomic factors, and stock prices can change rapidly. In this process, the CIO of a family office needs to keep the family members informed of market changes through timely communication, ensuring that the family’s overall judgment of the market is always aligned with that of the CIO.

Build trust relationships

In terms of communication methods, CIOs must inform the family of the risks present in the secondary market at the beginning of the cooperation, and “forcefully” instill and cultivate a long-term investment mentality in the family.

For the family, if the correct investment philosophy is not established early on, and they believe that allocating to the secondary market is just finding a trader to speculate in stocks, there will definitely be many problems in their future communication with the CIO.

In fact, there is a certain period of adjustment when the family office CIO collaborates with the family, which can be specifically divided into minor and major adjustments:

Minor adjustments refer to the experience of market fluctuations, without a specific number indicating how much it has increased or decreased. When the family and the family office CIO have experienced the market’s ups and downs together, having made money as well as lost money, they have undergone minor adjustments. In the secondary market, it is rare for prices to only rise or only fall within a few months. Therefore, the family office CIO and the family can experience a minor adjustment period within a few months.

In the fluctuation of the market, the family office CIO, through continuous communication with the family, generally will not encounter particularly significant problems. During the communication process, the family office CIO needs to make family members feel that they are on the same side and make the family believe that the family office CIO has sufficient professionalism and risk-bearing ability to manage the investment portfolio well.

· Great friction, that is, the family and the family office CIO have experienced a complete market cycle together, having gone through a bear market, economic recession, and recovery.

It is worth noting that in the past decade, there has not been a truly bad bear market in the market. For newly established family offices, it is very likely that they have gone through a smooth decade and have not yet experienced the huge fluctuations in the market.

This year has seen extreme market conditions. If the family and the family office CIO can work together to weather the downturn, the future bond between the two parties will be stronger, and the level of trust will be higher.

Note: The above content and views are for reference only and do not represent any position of our company. They do not constitute investment advice. Please treat them with caution.

Three key points of communication