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Short strategies for lean times

The seizing up of credit markets and the gut-wrenching volatility that hit equities in the second half of 2008 have tested the mettle of even the staunchest of long-term investors, high-net-worth families.

“Long-term investors over history have been paid to wait through these dips,” says Graham Spiers, the chief investment officer at Waypoint Advisors in Norfolk, Virginia. “Now, of course, this is going to be somewhat different.”

Different, indeed. A sampling of large family office operations indicates that advisors are emphasising cash and year-end tax-loss harvesting, and in many instances incorporating short selling strategies into client portfolios.

“From an asset allocation perspective, we are a long-term investor because we’re not looking at just one generation, we have multi-generations of families as clients,” says Judith Lau, president of Lau Associates, a multi-family office in Bethesda, Maryland.

But in recent months, the firm has accumulated cash in many client portfolios, and been restrained in adding new equity exposure to client accounts, says her colleague, portfolio manager James Lee. “We’ve found in the recent market tumult that there is no substitute for cash, especially in periods of financial de-leveraging. Our focus has been in US Treasury money market funds and Treasury bills. That has been very helpful for us.”

The MDE Group in Morristown, New Jersey, has also entered a cautious phase, encouraging its external managers who run separately managed accounts to increase their allocations to cash, while not completely exiting their strategies. “We’re not abandoning our long-term strategy by any means,” says John Longo, a senior vice president and investment strategist. “We’re taking down risk in a prudent manner as opposed to wholesale change to cash.”

Mary Malgoire, president of The Family Firm in Bethesda, Maryland, says she is not aggressively moving her clients’ reduced equity exposure back to their targets. “We are holding back on that – things aren’t clear. We’re making a judgment that we need to be cautious right now.”

She and her colleagues are also being “super-aggressive” in harvesting tax losses. This is also true at Chess Financial in Pepper Pike, Ohio. “Like a lot of managers, the fourth quarter has been active for us in terms of tax loss selling,” says chief investment officer Brad Turner. The traditional approach here is to sell a stock or bond that has a loss and reinvest in a similar bond or stock in order to keep the overall asset allocation.

“We have been doing a fair amount of that, but in some cases we’re also looking at an up-to-date cash flow model. Just yesterday, we sold approximately $200,000 of a security that was showing a loss for a client, but instead of reinvesting that in stocks, we decided to put that in cash because our cash flow model told us the client had a balloon payment on a vacation home mortgage coming in February 2009. Our thought was not to cut it this close, but to move that to cash. Yes, we’re underweighted in stocks, but the client said he didn’t want to go through the hassle of trying to refinance the mortgage, he just wanted to pay it off.”

Moneta Group in Clayton, Missouri, is taking a different approach. Thanks to a strategy put in place two years ago, most of the firm’s families have put enough assets into fixed income to live five to 10 years without ever having to touch their equity, says Linda Pietroburgo, a principal. Now the firm is rebalancing portfolios and putting more assets into equities. Pietroburgo acknowledges there has been some pushback from clients asking: why now? “We’re reminding them that we’re trying to buy low. We rebalance to re-establish the percentages.”

Investors engage in short selling either as speculators or to hedge their portfolios. “You’re going to see relatively few family offices shorting on a speculative basis or any kind of market-timing basis; it’s not part of the business model,” says Lee. “On the other hand, you may find a fair number engaging in some sort of shorting as a hedge position to a greater or lesser extent.”

Lau points out that like most family office operations, her firm doesn’t have the internal resources to engage in short selling. “We aren’t traders per se. In this time of extreme volatility in the markets, it’s exceptionally difficult to do well. Unless you’re on it all the time, that’s a very dangerous game to play.”

Lee agrees. “You need someone doing that full time because you have carry costs to short positions, and you have opportunity costs. Then you also have potential tax issues as well. It adds complexity in all three of those areas. We would rather have someone do that who is well acquainted with complexities and the strategies.”

Lee says probably the most common way family offices engage in short selling is through traditional hedge funds, such as those that use a long/short strategy. Lau Associates has invested in hedge funds for several years, says Lau.

Homrich & Berg allocates between one-quarter and one-third of its assets under management to hedge funds, according to chief executive Andrew Berg.

The Atlanta-based multi-family office accesses hedge funds using four fund-of-funds vehicles: “Most family offices would do it the way we do it because they’re not money managers; they don’t have the expertise” in-house to select and monitor individual managers.

The MDE Group also invests in hedge funds. “We don’t short sell individual securities,” says Longo. “We invest in hedge fund managers that do some short selling. Generally, their strategies have fared reasonably well this year, much better than traditional equities.”

Chess Financial does not engage in short selling. “Our investment strategy tends to be conservative and plain vanilla,” says Turner. However, a handful of clients, whom he describes as highly sophisticated investors, might consider a more proactive strategy of short selling in a more normal market environment. In the current environment, however, “all simply chose the route of paying down debt instead,” says Turner.

“They had the wherewithal and experience of engaging in short selling, but because part of this crisis has involved a seizing up and the malfunctioning of historically functioning markets, that diminished any appetite they might have had for it. Their feeling was simply: ‘let’s get the debt down’”.

John Morris, a principal at Boston-based Crestwood Advisors, says that although his firm doesn’t engage in short selling, other ways to mitigate risks exist. Particularly for large portfolios holding large positions here with significant embedded gains, “we’re writing calls against positions, a very conservative strategy to increase the income in a portfolio and also to mitigate some of the downside risk in client portfolios. It’s done in selective circumstances here.” 

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