Wealth management strategies get back to basics

It is time for family offices to get back to basics by asking the fundamental questions, most importantly: What does the family expect from its wealth? For many families, a steady but unspectacular return of 6% may suffice to fund the charitable foundation. Others will be content to inflation-proof their wealth while a smaller percentage look to higher-return strategies. But the important thing is to ask the question, writes Selwyn Parker

"It's such a simple exercise," says Bob Joel, head of 22 year-old single family office Timucuan in Jacksonville, Florida. "But so many families bounce around looking for the next great investment idea. They don't need a high-risk, 30% return."

With the big question settled, the search starts for the right custodian for the family's wealth. And that ultimately comes down to a clear-cut issue of whether the assets are entrusted primarily to the care of an individual with a proven record, of which Warren Buffett is perhaps the best-known, or to a particular system with a set of rules that are observed regardless of whoever is at the top. In short, the pilot or the plane?

Helpful clues are emerging. Hedge funds, which attracted huge swathes of family wealth, will surely be off the shopping list for a while. Some 215 funds closed in the first 10 months of 2009, according to the latest figures. Although that's not as bad as it looks because there are still some 2,300 funds left, many other funds – and especially funds of funds – are hanging on by the skin of their teeth after a flood of redemptions. Adrian Durrant of industry consultant eHedge explains: "A significant number of fund groups lost their credibility and their business due to their Madoff exposure."

Typically, hedge funds are pilot-driven in the sense they pursue the strategy of their founders but not even the best pilots can fly a plane that's broken.

But whether pilot or plane, track record is everything. By that yardstick, no family should go near the big global equity funds, at least until they've redeemed themselves over a few good years. According to Swiss consultant My Private Banking, the returns of the 15 biggest funds, including bank-run ones, were shockingly lower – and in some cases a lot lower – than the respective benchmark indexes. Only Deutsche Bank (4.3%), Merrill Lynch provider Black Rock (3.97%) and Lombard Odier (1.3%) out-performed the indexes while half of the remaining funds lagged by double figures.

To summarise, a common-or-garden exchange traded fund will do a much better job in the next crisis, and for lower fees. "It is very disappointing that the self-claimed wealth managers have performed so much worse than the market," concludes Geneva-based wealth manager Addvision Partners. It certainly is, and My Private Banking draws the inevitable conclusion: only invest "in those funds that have achieved above-average returns over many years."

Boring but safe may also be an axiom to steer by in the Great Recovery. Before the crisis, many families were attracted to quant-driven, allocative funds with impressively sophisticated programmes for balancing risk between multiple asset classes. But now the weight of evidence has moved heavily in favour of plainer, but not necessarily easier, strategies. Joel explains: "Investing is the polar opposite of Olympic high diving. There are no style points in investing. You only get credit for results, not for brilliant maths, amazing arbitrage or dazzling algorithmic formulae."

Indeed Norman Jones, chief executive of Denver, Colorado-based WealthTouch, a storehouse of investment data for UHNW families, notes that the post-crisis evidence is very much against the equivalent of high diving. "Big losses emanated from these funds that were triggering algorithm-driven buy orders all the way to the bottom and then sold at the floor," he says.

Another tip for the future is to look for flexibility. For instance, mutual funds – a favourite home for certain kinds of family assets – got hammered in the crisis. These follow easily understandable but strictly controlled strategies and almost by definition lack the ability to react quickly to changing fortunes. Predictably, as Jones points out, such funds designed for a much more benign environment could not cut it in the middle of chaos. He says: "The Fund of Fund Diversified Index was down 18% in 2008 while the S&P was down over 30%. So on the whole pilots have done better than the rules-based trading that mutual funds employed."

And while good pilots will fly around storms, sometimes they have to fly through them. The ability to recalibrate a strategy, albeit while remaining faithful to the investment philosophy, has long been the hallmark of a great wealth manager. "You've got to hold your nerve," explains Joel.

Jones adds: "[Families need] somebody who is willing to reshuffle the deck quickly to protect assets. A fund that has just performed well or even very well in good times is not enough. On the whole pilot-driven funds did better as many used their intelligence to think their way through the crisis."

Longer-term strategies are looking good too in the post-crisis world. After many years in the wilderness, we're back to "patient capital", to the delight of many family offices that have stuck with their investments only to be frustrated by institutions with a fistful of proxies and a short-term strategy. But salvation is at hand. Under new chief Mary Schapiro, the Securities and Exchange Commission is taking a long, hard look at proxy-voting and short-term hedging, both of them fuelled by cut-price share-dealing and press-button trading technologies.

The attack on short-termism isn't new. The Aspen Institute launched an offensive against it nearly three years ago but the tide of opinion was then against it. Now however, famously patient investors such as Warren Buffett have signed up to the campaign and the prospects look better. As Judith Samuelson, executive director of the Institute's business & society programme says: "Short-termism must be addressed as a conceptual whole – piecemeal approaches do not work." In practice, that means federal laws that embed "patient capital" into the investment world.

None of this can come soon enough for James S Crown, another signatory to the Aspen Institute's campaign. President of the $4.8 billion, family-owned conglomerate Henry Crown & Coy, he's the archetypal long-term investor identified with the Chicago Bulls and New York Yankees.

Allied to this is the mounting consensus that it's safer to back specialists than all-rounders. In the wash-up from the carnage, it's becoming clear that managers who attempted to juggle multiple asset classes came off badly. The role of diversification is usually argued on the principle that safety lies in spreading risks (as well as bringing in more assets and fees). However in the light of the crisis, it's now thought that too wide a range of assets merely serves to increase the dangers. "Only invest in assets you understand," underlines Joel, a confirmed Buffett-style value investor.

In most investment matters, consensus is just about impossible but one thing on which everybody agrees is the need for open dealing between managers and clients. "Clients should demand complete transparency from their advisors concerning the allocation, the quality and the cost of funds in their portfolio," insists My Private Banking.

Jones adds: "Families want access to the pilot and they want to be confident that the pilot is doing what he said he would. At the end of the day it is about transparency and communication."

But even the best pilots can make mistakes. Lawrence Summers, former US Treasury secretary and now president Obama's chief economic advisor, blew a bundle while president of Harvard University. He persuaded the managers of its huge endowment fund to invest some 80% in cash, double the normal weighting. Although Summers had by then resigned, the fund continued to pursue the strategy and lost $1.8 billion in the meltdown.

And former clients of Bernard Madoff need no reminding that it's vital to look beyond the reputation of the pilot. "Investors are often swayed by the big name, the figurehead," warns Joel. "Make sure there's a deep bench behind him. A good pilot is really a conductor".

Finally, one of the smartest questions to ask the potential pilot is how many clients he has. A recent survey by consultants PricewaterhouseCoopers found that, of firms managing family portfolios worth $50 million and higher, the average ratio of relationship managers per client was 1:18, which could be too many. The highest-performing firms ran ratios as low as 2:1. "Taking care of the client really does provide its own rewards," summarises PwC. 

How to select wealth managers

• Look for a carefully defined philosophy and, if there is one, its compatibility with the family's specific goals for its wealth.
• Is the firm's strategy based on long-term investing or is it highly reactive?
• Ask detailed questions about the fund's specific expertise and establish to your satisfaction whether the managers fully understand it.
• If there is a proprietary investment system, expect it to be explained in five minutes. It is said Einstein could explain the theory of relativity in two sentences.
• Find out whether a much simpler and easily understood strategy would achieve similar or better results.
• Rate the performance of the fund in current and earlier crises compared with the performance of peers and the markets.
• Since even the best firms make mistakes, be satisfied with the explanation for one or two indifferent years and what the firm did to right the ship.
• Look for a hands-on, professional investor, somebody who is "managing the farm", rather than a salesman or figurehead.
• Insist on meeting the rest of the team to assess their competence and experience, particularly the point man for the family's wealth.
• To test the firm's openness and transparency, get detailed information about its reporting systems and its availability to a designated family member in the event of questions.