Melanie Stern is Section Editor of Families in Business magazine.
Melanie Stern examines the use of alternative investments in family office portfolios across the world
Although alternative investment is said to be a relatively new market, the family office sector – at least in the West – has used it to realise wealth management aims for many years, attracted by a low correlation to traditional, volatile markets and the excellent risk diversification available. No spectacular revival is expected shortly from the stock markets, so for the moment, consensus is that interest from family offices and other high net worth investors will keep growing.
In June this year, Merrill Lynch's World Wealth Report reported that "the average" high-net-worth individual invested approximately 10% of their assets in alternative investments in 2002, and found that the higher the wealth band, the higher the proportion of the investment portfolio was invested in this field. "High- net-worth individuals currently account for approximately 60% of total hedge fund assets under management," the report claimed, adding in a later report that it found total global hedge fund investment fell at US$563 billion. In fact, the number of family offices investing the majority or sometimes all of their funds into alternative assets is at a level to underpin the confidence family wealth managers have in the market – alternatives are all the rage.
To investigate any geographic or cultural nuances in the use of alternatives, Families in Business interviewed three family offices – one each in America, Europe and Asia.
What emerged was that Asian families are still in the process of understanding how alternatives fit into their portfolios, and streamlining their assets to reflect that, while American family offices are the most confident of alternative asset users, with a heavier leaning towards the market than anywhere else generally. Europeans, meanwhile, understand the value of alternatives but take a more conservative approach to their implementation.
The common thread was the aim of bringing down overall portfolio risk by diversifying each individual risk as thoroughly as possible, commonly executed via arbitrage or distressed debt strategies. This illustrates that family offices, however comfortable with the returns seen on alternative investments, are still at pains to distance their family wealth from the effects of ever more volatile financial markets – business families are taking braver steps to become more involved in complex markets, though underneath they remain cautious.
Zurich-based Marcuard Family Office manages 32 family business clients and their combined assets of Eu550 million. It holds about 30% of those assets in hedge fund strategies, broken down into three areas – private equity, typical hedge funds and long/short equity.
Marcuard began hedge fund investing in 1990, at a time when the market was limited to just a handful of funds and star managers, including George Soros and Julien Roberts. In 1999 it stepped that activity up by partnering with a leading American single family office – for US regulatory reasons the name of this institution is not disclosed – launching two funds aiming for the ultimate diversification. The Diversified Fund is a fund of funds that employs 36 'sub-advisors' with just 0.4% correlation to the equity markets, while the second is a supra-cash fixed income fund with 0.3% correlation. The combined funds have returned 7.3% a year to their respective families. "The reason we set these up was to have a team with a proven track record and the ability to design a portfolio that is truly diversified," Marcuard's Ulrich Burkhard, Managing Partner, explains. "We are doing well because these hedge funds bring us a bit of stability and fairly good predictability in risk and return terms – sometimes hedge funds are too directional or take on too much risk, but we wanted neither. The two strategies together truly do bring down the portfolio's volatility."
Burkhard adds that Marcuard has been able to reduce one of its client's total portfolio risk level to a volatility of 5% compared to the benchmark of 8.3% by creating a portfolio composed 5% in cash, 15% in bonds, 35% in global equities, 35% in hedge funds and 10% in private equity – so without confusing with too many percentages in one sentence, this represents a 40% drop. The only downfall of this strategy is that market recovery reduces its return, with 2003's at 80% of benchmark (though with only 60% of the benchmark risk).
Mindful of manager risk (see article "FO's and alternative investment: the quest for Alpha") eroding long-term returns or bringing in too much risk, Marcuard prefers to use fund of hedge fund structures that invest in groups of managers, diversifying that risk as far as it can be taken. "In a hedge fund of fund portfolio with 50 managers, the risk of something going wrong with at least one of those managers over a five-year period is very high. As a consequence, managers of family money must focus on diversifying their managers well, measuring and managing the risks, and selecting a management team that really understands this field," Burkhard believes. "Investing in traditional products like equities is totally different to investing in alternatives; it is a different responsibility. I would argue that most private bankers, for instance, do not have the know-how to do a good job there."
Sterling Enterprises is a single family office for the Hong Kong-based Chen family, involved in property development. Roy Chen is a family member and director of the family office, which manages funds "in the nine-digit range."
Sterling classifies over 40% of its funds as being in alternatives, with 35% of that in absolute return strategies and the rest in long-biased hedge funds. This includes event-driven, arbitrage, distressed, high yield and a range of multi-strategy hedge funds. Outside alternatives, Sterling invests in a range of long-only equities and fixed income strategies.
The family office has used alternative in the broadest sense for a decade, but when they realised that markets were growing at a much faster pace than they had seen before, and that their current set-up could not take advantage, they decided to better organise their exposure. In 1999 the family enlisted a consultant to determine their investment objectives and form an asset allocation model. "Considering where we started, we've come a long way," Chen admits. "Prior to (using a consultant) we were more opportunistic – and to put it bluntly, a bit haphazard in our approach. Although we had been in hedge funds for a long time, we weren't clear about what or why we were investing in until quite recently. In fact, most family offices in Hong Kong use alternative investments, but they can't always tell you what it means."
While Sterling does not disclose performance, Chen explains that only one or two of its strategies have underperformed in 2003 to date, but highlights the distressed strategies and high yield strategies – which encompass a range of strategies from traditional balance sheet arbitrage to credit-driven arbitrage – as the most successful. Sterling's event-driven funds are growing in activity and arbitrage in specific, Chen reports, levelled off mid-year. "Compared to Nasdaq, our performance really shot up this year, though for us hedge fund exposure is not meant to mimic that kind of volatility," the director explains.
Chen is in the process of considering investing in a range of fund of hedge fund products as part of the family's absolute return sub-account.
William AM Burden & Co family office manages the wealth of the Burden family. The Burden family are descendents of the Vanderbilts, the infamous New York-based railroad magnates.
The Burden family office invests 100% of its funds in alternatives, a move officially made in 1995 by director, Jeff Weber. "We had net long market exposure in the mid-1990's and I viewed the US markets as becoming expensive, so we wanted to position our portfolio as a market-neutral one," Weber explains. "We also noticed then that our hedge funds were dramatically outperforming our long-only managers, both in good markets and weaker markets, so we started investing more and more in hedge strategies until we became 100%. From set up in 1949 to 1989 the capital was managed as a long/short equity portfolio with some venture capital – so it was really always a portfolio positioned for alternative investments." Additionally, Weber explains that for a publicly listed family company that already has considerable market risk and volatility exposure, alternatives' low correlation to traditional instruments keeps extra exposure down.
The portfolio features long-biased private equity and real estate, while its hedge fund exposure focuses on multi-strategy arbitrage providing absolute return. The office still holds some strategic long-only block investments in the form of private deals that have gone public, though their source was private equity transactions. It has a hedge fund-collateralised credit facility providing liquidity management for the family members, which Weber says solves the issue of illiquidity in alternative investments.
William AM Burden does not disclose performance but Weber concedes that it has outperformed the market for the past 11 years. Will the family office ever reduce its total alternatives exposure? "It would depend on the public equity markets becoming considerably weaker, and in my view bond yields will go up, so we won't invest in fixed income," Weber reveals. "The way asset management is moving towards alternative instruments, I think the relationship between alternatives and family offices will only grow."