For ultra-wealthy families, investment is often seen as the family office’s (referred to as “FO”) main function, and one of the core factors determining the success of the family office.
Currently, more and more family offices are managing multi-asset investment portfolios that span global markets. It is worth noting that the investment decision-making process has a certain level of complexity. The failure of family offices to achieve targeted returns and unexpected fluctuations in investment portfolios may be due to the lack of a robust investment process and investment experience within the family office.
So how do top-tier family offices make investment decisions?
When assessing its readiness and adequacy in investment capabilities, the family office should first ask itself the following three basic questions:
• Is there a rigorous and repeatable investment process, a clear and regularly reviewed investment strategy, and regular performance assessments related to the predetermined benchmark?
• Do you have the necessary internal or external investment experience, personnel, content, and technology to properly manage the quantity, type, and complexity of the assets under management (AUM)?
• Are you actively communicating with the investment team, clients, external advisors, and family members?
01 Original question
There are six common elements in the internal or outsourced investment process of a family office:
- Investment Policy Statement (IPS), which specifies the specific goals, time frame, and benchmarks of the family’s investment portfolio;
- An asset allocation plan that reflects the true risk tolerance of family members;
- Effective portfolio construction, based on rigorous investment research analysis and ongoing monitoring;
- In-depth performance reporting on a regular basis, against benchmarks and targets.
5. Risk management practices for managing downside risk and excessive volatility
6. Clear decision-making and communication processes
For family offices, an Investment Policy Statement (IPS) is a cornerstone document that includes:
• Defining the family’s investment process
• Setting investment parameters, including limits on individual positions and market exposure
• Defining responsibilities, authorities, and the structure of the investment committee
• Specify the frequency of portfolio rebalancing
• Establish benchmark performance standards
In addition, the investment policy statement also defines the roles and responsibilities of employees, asset managers, custodians, and advisors. The process of developing a family investment policy statement provides a unique opportunity for family members, family office staff, and core advisors to engage in in-depth discussions around investments. It should also promote critical dialogue and be reviewed at least once a year to reflect market conditions, changes in family goals, and experience in managing the investment portfolio.
02 Investment Process
A large number of academic studies have confirmed the importance of asset allocation and its impact on portfolio returns and volatility. A sound asset allocation model includes the expected returns of investment attributes and global asset categories, as well as the investment returns, risks, liquidity, and behavioral biases stipulated in the investment policy statement.
Asset allocation will display the weights of the best asset categories in the family’s investment portfolio, as well as the risk parameters and liquidity of the portfolio. This involves four core elements:
- Determining the family’s main needs and preferences for after-tax returns, expenses, volatility, risk exposure, liquidity, and areas to avoid or prefer, such as emphasizing social impact investments;
- Analyzing the returns of asset categories under different volatility, correlation, and extreme downside risk scenarios;
- Make a series of investment allocations in core asset categories and subcategories;
- Make thoughtful judgments on the best combination of assets, giving appropriate attention to the family’s real risk tolerance.
Effective asset allocation requires good quantitative skills, as well as investment judgment and experience. Although modeling will produce a range of possible configurations, fine-tuning the investment portfolio to reflect the behavior, subtleties of the client or family are often the difference between success and failure.
Developing a portfolio has two core elements – the rules related to building the portfolio, and the principles related to selecting managers or the content of the portfolio.
Manager selection is a means of implementing the portfolio. It first assesses whether passive indexing or active management is suitable for each asset class or geographical risk exposure in the portfolio. For example, the ability of active managers to add Alpha is a major consideration.
Given these investment risks and the long-term nature, as well as the potential role in portfolio diversification, using alternative investment managers is also a key consideration for investors.
03 Asset Allocation
The ability of a family office to effectively construct and manage investment portfolios largely depends on investment research, which includes personal manager research as well as macroeconomic analysis. Mature family offices often develop external resources to effectively access and synthesize vast amounts of data.
Typically, these resources include investment advisory committees, consulting firms, and private banks. The responsibility of the family office is to carefully select and deploy external resources to implement an investment policy statement, with the goal of seeking excellent returns.
As the complexity, size, and diversity of investment portfolios increase, performance reporting has become a focus for family offices. Family offices are increasingly hiring a more diverse range of asset managers based on their style, type of assets, or geographical location.
Considering various factors such as currency, asset valuation, etc., makes the integration, analysis, and reporting of performance more difficult. Many family offices turn to bank custodians for integrated reporting solutions to address the integration of tax account data, the processing of corporate actions, and the preparation of reports.
In terms of performance reporting, the best solution for family offices is to provide performance data and customized benchmarks for each asset class, asset management company, and family branch, thereby identifying key portfolio characteristics and risk indicators.
Risk management begins with identifying the core risks that may affect the portfolio. These portfolio risks are divided into two major categories: systematic or market-level risks, and unsystematic or specific security risks.
Based on this analysis, the family office must define practices for measuring and monitoring these risks, and determine risk prevention measures and define risk mitigation strategies.
Other key areas of portfolio risk management and reporting include:
• Exposure risk: Factors that generate positive and negative returns;
04 Portfolio Construction
• Counterparty or Agency Risk: Concentrated or absolute exposure to one or more companies involved in the issuance, management, holding, trading, or control of assets;
• Illiquidity Risk: The inability to access portfolio funds within one or two quarters, primarily due to bankruptcy, lock-up, side pocket mechanisms, general partner extension of fund life, or unpredictable portfolio exits.
In many ways, capability risk is the least recognized and discussed risk for family offices. This is especially true for family offices with complex multi-asset investment portfolios but limited human resources or investment experience.
Engaging in hedge fund strategic investments, direct investments, venture capital, and conducting complex capital market transactions further increases capability risk, often requiring family office employees to have more in-depth experience and skills.
The best way to understand and mitigate capability risk is to be frank and thorough in identifying the strengths and weaknesses of the family office’s resources (staff, technology, content, and investment practices) relative to investment needs.
Based on the results of the assessment, it is possible to identify and fill gaps in capabilities internally or externally, or to avoid investment.
For family offices that wish to address deficiencies in research, investment, trading, or supervision of investment managers, there are many external alternatives. At this point, even the most mature family offices or family investment companies may face such challenges.
05 Performance Report
Communication between family members, family office executives, and staff is a key factor in successful investment and also a major risk factor. We often observe that this communication is neglected or taken for granted.
There are four aspects of communication management in family offices:
• Principal communication plan – Understand the behavior and decision-making patterns of the principal, define communication modes and frequency, and create a “common language” to make interactions between the principal and the family office clearer and more efficient.
• Investment team communication – Organize necessary team meetings and communication around the life cycle of the investment portfolio, check returns, risks, managers, costs, performance attribution, and other factors.
All of this needs to be organized to avoid tendencies towards “groupthink” and “cults of personality,” and appropriate team communication meeting records should always be maintained.
• Family communication – The content that needs to be shared with specific family members should be carefully defined. This should be based on roles and ownership of assets, the form and frequency of communication, and the decision-making preferences of family members.
• External advisors/managers communication – Generally, this communication covers macroeconomic and market updates, changes in investment arguments, reviews of allocations and investments, and forward-looking views of the portfolio and factors that may trigger changes, etc.
The frequency of such communication and meetings depends on the nature of the consultant or manager role, as well as the relative importance of the portfolio. In addition, the family office should also keep written records of recommendations, actions, and follow-up actions.
06 Risk Management
Family offices should regularly review their investment strategies and their effectiveness. Some family offices assess their own capabilities, while others evaluate operational efficiency through advisors. Regardless of the approach, it is crucial for family offices to answer the following questions:
1. Has the family office established a core investment process, taking into account the ability to implement it based on any unique characteristics and changing needs?
2. Is the family office’s investment process implemented in a consistent manner?
- How does the family office’s investment portfolio performance compare to relevant benchmarks and peer data?
- Does the family office have the appropriate resources (personnel, experience, data, and systems) to consistently and effectively execute these processes over the long term?
- Would it be more valuable for the family office to outsource these activities to increase or replace them?
The failure to achieve consistent long-term investment portfolio returns is often incorrectly attributed to poor investment decisions, unfavorable economic conditions, or hiring the “wrong” investment managers.
However, the root cause of poor or inconsistent investment portfolio returns for family offices can often be traced back to deficiencies in the investment process, resource allocation, and communication.
In summary, family offices can only achieve the desired investment returns through a systematic and repeatable process, appropriate resource adjustment, and in-depth communication among key participants.
