In the recent Managing Family Wealth video series broadcast on campdenFB.com, family office founder Bertrand Coste said: "The reason we have a family office is so our investment strategy is more transparent and so we don't have to rely on the advice of private banks or independent advisors. Some private banks sell products not advice so we prefer to rely on our own due diligence and expertise."
As a family office executive and an ex banker myself, I can confirm that Bertrand Coste is right, writes Alexandre Arnback. Bankers are salesmen who are required by their employers and motivated by a bonus system to sell ever more products and services. The products are made to increase their financial institution's profitability and consequently, their shareholder value.
Conflict of interest can also twist the best intentions of so-called independent advisors who make commissions on selling other people's products. Equally, it can also affect investment managers in family offices who have previously worked for a bank but have difficulty accepting that what they were doing when they were bankers does not produce the same value for a family office.
Family offices put considerable energy into looking for the best investment managers. However, I came to realise that no matter how hard I worked to identify the best fund, the investments I selected had an 80% chance of underperforming the market. In other words, I was working hard to bill our clients for the high probability that they would lose money. I was failing.
Consequently, I decided to take a different angle and realised there are two possible investment philosophies:
• Active management, in which you try to beat the markets
• Passive management, in which you accept market returns.
Have you measured your investment outcomes recently? If you have, you should have come to the same conclusions as all the academic studies from the last 40 years: it is difficult, risky and expensive to try and beat the markets with active management. For instance, the last study from Chicago University shows that only 1.4% of managers beat the markets five years in a row.
Even when you analyse the managers who did succeed, it is impossible to distinguish luck from skill. And worst of all, a recent study from S&P (SPIVA) shows that past losers have a higher probability of future success than past winners.
Sometimes the solution lies in simplicity, which brings us to passive management.
Passive management is generally not well understood. It is not a product, rather it is an asset management technique. Instead of relying on forecasts, which are expensive and uncertain by definition, it relies only on science. Here are five basic tenets of passive investing:
• The lowest possible risk is a well diversified, high quality short term bond portfolio in your currency
• Over time, companies create value and the economy grows
• Risk and return are directly related
• Diversification works
• Fees eat up your capital, so minimize them
With the above, you can build a robust portfolio that cannot fail. For instance, you can build a portfolio that contains 50% bonds and 50% MSCI world tracker. That simple portfolio is cheap, cannot lose 50% (it would mean all the large cap companies would have to go bankrupt) and will beat most managers with a similar 50/50 risk profile over time.
I am convinced that all family offices will ultimately have both active and passive management in their portfolios. Active portfolios give the satisfaction of sometimes beating the markets, while passive portfolios are failure proof but will never beat the market.
I have met only one family office that is invested 100% passively. When I asked why, they said it gave better performance with the lowest risk. "Once you try passive, there is no way back," said the CFO.
But before you commit either way, I strongly recommend that you ask yourself the following questions:
• How do you measure the investment performance of your family office? For example, is your benchmark a true market benchmark or a theoretical one?
• If you do active management, how do you ensure your investment managers are encouraged to create real value?
• How do you hold your investment managers accountable for their performance?
I suggest that when you rigorously analyse your performance you will find that active management has a high probability of failure and that the introduction of passive management into your investment strategy will benefit you in the long term.