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October 5, 2016

Should you invest like a family office?

Are you having trouble deciding where to put your money now that everything seems expensive and interest rates are around zero? Should you try to mimic what the Family Offices do that manage the fortunes of the richest people globally? UBS has published how the Family Offices invest and what results they have achieved over the last three years. Here we take a closer look at their investment strategies and if they are suitable for you.

Mythbuster #1: billionaires have a better investment performance

It is easy to get whirled up in the excitement of the investments of the millionaires and billionaires. But we are not here to write another eulogy. We just want to analyze the performance these family offices have delivered and what we can learn from them.

We published research in March showing that the much lauded US university endowments have failed to beat a simple index investor over the last 5 and 10 year. Are the Family Offices better or they just more hype than substance?

We will compare the performance of the Family Office with a basic 60% equity and 40% bond allocation. We have chosen to use a simple index that investors can replicate at low-costs with an index fund (ETF). For equities, we take the MSCI World Index and for bonds, we use the Barclays Global Aggregate Bond Index. As the following table shows, this simple 60/40 portfolio would have outperformed over the last three years with a CAGR of 5.6% versus a CAGR of 4.9% for the Family Offices. Yes, a lot of nuance is lost with this simple portfolio. But a lot of noise is left out too.

 201320142015CAGR
Family Office8.5%6.1%0.3%4.9%
60 equites / 40 bonds15.4%3.5%-1.5%5.6%

Mythbuster #2: billionaires know better

Asset allocation is the key starting point for a successful investment strategy. If you get this wrong, you cannot expect superior performance. Alas, Family Offices as presented here in the UBS study display an asset allocation that is far away from what the best institutional investors do. It is no surprise that Europe’s largest investor, Norway’s Pension Fund has delivered a better performance over the last 3 years. We just highlight two points where Family Offices deviate from best-practice.

 201320142015CAGR
Family Office8.5%6.1%0.3%4.9%
Norway Pension Fund16.0%7.6%2.7%8.6%

Mistake 1: Too much complexity

A portfolio is not better simply because it holds more positions. Too much complexity is often driven by the need of advisors to justify their fees. But as the table above shows, a simple portfolio can deliver superior risk-adjusted returns. Too many positions increase management effort, reduce transparency and improve diversification only marginally.

family-offices-asset-allocation

As an example, we point to the commodity position of the typical Family Offices as presented by UBS:

  • Commodities offer no real returns. Why should they? 1kg of copper will still be only 1kg of copper in 10 years from now. There are many studies showing that commodities should not be part of a long-term portfolio.
  • A 2% position is simply close to irrelevant. Even if the price of commodities goes up by 40%, this only increases the position from 2.0% to 2.8%. Such a small position is a management distraction and serves only to tick a box.

Mistake 2: Alternative assets are NOT a unique asset class

Many consider investments such as hedge funds and private equity as stand-alone asset classes that have little to do with more traditional asset classes such as stocks or bonds. But this is wrong. A useful way to think about alternative investments is to differentiate between “contents” and “containers.” If a Hedge Fund invests in stocks, then the asset class is equities, not alternative assets. If a private equity firm invests in property, then the asset class is property, not alternative assets.

Alternative assets have one main advantage: no mark-to-market. This is important for a conservative client base which does not like the wild swings of the financial markets. But in the end, this is merely an illusion. Just because you don’t get live-ticks, doesn’t mean that year asset values cannot change wildly.

It is important for investors to separate facts from fiction. If alternative assets were such a superior asset class, why then are the returns so abysmal? After all, they are often illiquid and therefore investors should receive an illiquidity premium. But when we look at the results of the Family Offices, this does not become apparent. In April we have analyzed the 10 year track-record of some alternative assets and the results were disappointing.

One does not have to be a cynic to see who benefits most from a shift towards higher fee alternative asset managers (hint: not the investor). We have said it before many times: alternative assets are not so much a distinct asset class as they are a wealth transfer mechanism. From your pockets to the pockets of the fund managers and the banks.

What explains the poor results of Family Offices?

This is referred to as the agency problem. It is a conflict of interest inherent in any relationship where one party (Family Office management) is expected to act in another’s best interests (shareholder). The manager, acting as the agent for the shareholders, is supposed to make decisions that maximize shareholder wealth even though it is in his own best interest to maximize his own wealth.

What is at stake? If the Family Office can deliver superior risk-adjusted returns with a simple portfolio consisting of index funds, they would quickly lose their high-paying jobs. It is in their own interest to make the investments as complicated as possible.

Bottom line

Investors should be careful when imitating the investment strategies of the rich and famous. There are literally thousands of small and mid-sized institutional funds — foundations, endowments, pension funds, family offices etc. — out there that are being mis-managed. They are getting poor, and often conflicted, advice. They are investing in things they do not understand. The fees they are paying are too high. Most have not established any legitimate guidelines or investment policy statements.

While institutions have many advantages over private investors, they often squander these opportunities by defaulting to a complex investment posture or short-term thinking.

One of our goals is to educate our clients. We want to clear away the nonsense and the fear around investing for our readers. Investing is not a mystery science but there is a list of trusted principles that can help you reach your financial goals. If you would like to know how we can help you to reach your goals, please get in touch.