This week, the wage price index demonstrated that real wages are struggling to keep up with the rate of inflation
The strategic role of asset allocation for family offices
Central banks are looking to raise interest rates to contain rising inflationary pressures after US core inflation hit 5% in March, reaching a 40-year high.
Central banks are looking to raise interest rates to contain rising inflationary pressures after US core inflation hit 5% in March, reaching a 40-year high. Given several compounding factors—such as the conflict in Eastern Europe, supply chain constraints, rising commodity prices and the fear of spooking global equity markets—central banks have been cautious with their stance and explicit with their communication to the market. It is always challenging to navigate and manage the right portfolio allocations during periods of volatility, particularly when the outlook is clouded and uncertain. So, how should family office managers explain challenging periods of performance and what should they do?
First, family office managers should be reminded of the fundamental success of portfolio management and should be constantly revisiting their objectives to ensure that they achieve the desired outcomes they are looking for from their investments. Given today’s rapidly changing markets, this takes on an even greater importance.
Toward the end of 2019, models reflected some tight compression of returns across most asset classes. That year, it would have been difficult to gain conviction when consumer confidence was low, company earnings were benign, company balance sheets were highly leveraged for companies that took advantage of the very low-interest rate environment? and manufacturing data was mixed between contractionary and expansionary phases. To make matters worse, by August the yield curve had inverted while some asset price valuations were well above long-term averages and the U.S. and China engaged in a trade war. However, at the same time, central banks were on an aggressive path to stimulate economies with quantitative easing programs and most held their interest rates low. As a result, many investors responded by chasing yields in other asset classes outside of traditional fixed interest markets—a dynamic that has forced investors to move up the risk curve. Equity markets and inflows into funds were major beneficiaries of this movement in capital, breaking new highs and, more specifically, increasing the price of growth stocks that benefited from the low-interest rate environment.
The complexity of markets is compelling for family offices, investors and non-investors alike, as is the lure of chasing returns. However, it is sometimes forgotten that ultimately, investing is about meeting objectives and there is no such thing as a ‘one size fits all’ approach to asset allocation and/or portfolio construction. Having to meet investment objectives provides the structure to construct a proper portfolio rather than just punting around the edges. Decisions on allocations and portfolio sizing should reflect and meet the family office’s needs first and foremost, as opposed to measuring up against the biggest returns. For example, venture capital (especially in technology) has shifted in reporting returns in percentage terms to multiples of return on capital. If the objective is to meet shorter-term liabilities—for example, to pay school fees for the beneficiaries or pay for a deposit on a business/real estate transaction or philanthropy—then holding a long-term, illiquid venture capital investment on 8x of the capital invested (i.e., every dollar of investment is now equivalent to 8 dollars) would not have met the objectives if the family office is unable to satisfy the liquidity needs of investment when required.
Having changing needs or even multiple objectives (to satisfy many stakeholders) is a function of family offices and charities alike. With ever-changing needs and increased challenges, reliance on the returns of the investment portfolio becomes more fundamental to meeting the objectives of the family office. It needs to be reflected and fleshed out with your advisor or investment manager so that the most appropriate portfolio may be built to align with your short and long-term goals.
If you have not revisited the goals and objectives from the perspective of liquidity requirements over different time periods, your appetite for being able to tolerate market drawdowns and more broadly your return ambitions (both income and capital growth), now is probably not a bad time given the valuation of listed markets and the opportunities in the unlisted space. Working through these key fundamentals may provide opportunities within the portfolio to capitalise on spaces where there may be uncorrelated returns. This could also lead to exposure in alternative spaces that provide a potentially strong future return profile on a risk-adjusted return basis.
Here are questions advisors or gatekeepers to family offices should consider with respect to their portfolio:
Are returns in line with expectations given the family office’s objectives? Is the advisor/gatekeeper reviewing the performance independently and giving guidance on possible courses of action? Does that advisor/gatekeeper have the respect of the other family members, such that they will listen?
Is the portfolio structured to balance risk versus returns when taking into consideration future liquidity requirements of the family office or risk tolerance? Is there also a buffer for unexpected liquidity events?
Are the returns better than expected? Is the family advisor articulating to other members of the family whether the current strategy may face challenges?
If the returns are going through a period of underperformance, is the advisor/gatekeeper within the family reviewing the process and style while providing support? Is the advisor/gatekeeper prepared to make the difficult decisions to change course? How often should the portfolio be reviewed?
Is the culture within the family office one where the advisor/gatekeeper is supported through difficult and challenging times, or left to fend for themselves?