Nicholas Khan-Roper, Chartered FCSI, chief investment officer and head of wealth at Advantage Family Office in Dubai, outlines the impact of different methods of asset allocation on portfolio performance
A family office is a privately held entity or company, set up for the sole purpose of managing the assets and affairs of a single family or a group of single families. Assets are personal and investable, and affairs relate to the softer side of the advisory scope. This could include advising on the purchase of a private jet or even selecting schools for the children.
The concept of the family office has been around for many years, with the Morgan family being a good early example. The House of Morgan, originally set up to manage the affairs of the family, grew into what has become the behemoth organisation known as J.P. Morgan.
A family office can be a single family office (SFO), a multi-family office (MFO), or can offer single services focused on advising ultra-high-net-worth (UHNW) families.
The SFO is an entirely different beast to, say, an MFO such as Stonehage Fleming and Glenmede. SFOs can be more agile, tend to have more resources per client and most importantly, are less restricted in their focus. They are more like a hedge fund for a single family than a traditional wealth manager. They can be dynamic and can reduce risk by removing risky assets when necessary and taking on excess risk when it is advantageous to.
This article focuses on asset allocation considerations for SFOs, with a core focus around allocation to capital markets.
Asset allocation as the key driver of returns
While the school of investment management constantly evolves, one theory seems to endure: asset allocation is the single most important defining factor on portfolio performance. This concept has however been diluted and misinterpreted over the years through poor translation.
Asset allocation is formed around the theory that different asset classes are non-correlated, so when placed together will create optimal risk adjusted returns. However, 2008 proved that this theory doesn’t always hold true and where assets had a capital fluctuation, they all tended to correlate positively.
"Rule No1: Never lose money. Rule No2: Never forget rule No1" – Warren Buffett
So how does an SFO decide how to optimise its portfolios to minimise capital loss and maximise gains, given that they are not constricted in what they can and can’t do like, say, a pension fund or an MFO? There are several strategies available to them, but in my opinion the most optimal is dynamic asset allocation.
Types of asset allocation
Strategic asset allocation (SAA): Static allocations with rebalancing at various points. This is the basis for more traditional allocations. In this process, allocation is constructed looking at risk profiling, investment objectives and time horizons, the latter being of extreme importance, and, if used with competent and regular financial planning, can be very effective. More recently, the concepts of lifestyling and target date strategies, used by the likes of Vanguard, countered the importance of time horizon by strategically aligning allocation to a target date or period, such as retirement.
Tactical asset allocation (TAA): Built upon SAA, it attempts to tilt allocations according to a view on macroeconomic events.
Multi-asset class (MAC) portfolios: Static in essence. This approach suggests an advancement on the traditional 60/40 model of equities/bonds and instead splits portfolios into, say, five asset classes, each with an equal weighting. One would rebalance as and when a particular asset performs, and another underperforms. The idea is to minimise market risk altogether as it was believed many assets were non-correlated. The concept of a diversification being a ‘free lunch’ was pioneered by investors such as David Swensen and John Duffield and taken to its extremes. What the credit crunch harshly taught us was that most assets classes correlate positively when there are periods of extreme downside risk (EDR).
Dynamic asset allocation: Where one can move entirely out of and into any asset class with little or no constraints. Cash is seen as an important asset class and ballast, with fixed interest deposit being a place to park capital short-term, removing market risk to a large degree. With this style of allocation, the idea is built around the premise that as the market risks and opportunities change, so should the asset allocation. If markets are dynamic, surely allocation should follow suit?
Defining risk and return parameters
Dynamic asset allocation is not a sector wide practice, mainly because shifting allocations is time consuming, can be expensive and not every mandate allows for this approach. SFOs are not subject to these constraints and can benefit from the deployment of these techniques.
This topic merits an entirely separate discussion and so will only briefly be touched upon here. What needs to be underlined is that if one is following a dynamic approach to allocation, one cannot use traditional definitions of risk profiling where portfolios are built around a risk/return model. Instead, goals should be set and a target return approach to allocations formed accordingly. For example, I run several portfolios for the same family but with different target objectives, target returns and most importantly, time horizons.
They do have one thing in common, a theme which seems to run true across many SFOs. No matter what goals or what target returns are to be met, the same underlying philosophy applies: create the optimal portfolio without losing capital. As billionaire investor Warren Buffet said: "Rule No1: Never lose money. Rule No2: Never forget rule No1."
This applies if your target return is 4% or 20%. So how is this done using dynamic asset allocation techniques? By following as a guideline a strategy of investing called business cycle investing (BCI). One is looking to dynamically allocate to assets depending on where they are in the economic or business cycle. Good chief investment officers have a core focus on top down, macro research rather than a bottom up focus on company selection. This applies to the capital markets portion of the portfolio, with many CIOs still opting for direct analysis and investing at a start-up level. Bottom up equity selection can be outsourced to some of the best managers in the world through mastering the art of fund selection. If you couple BCI with market sentiments and opt to be more cautious, then getting fairly accurate timing becomes more likely. For many SFOs, contrary to what the sector likes to inform us, market timing is a key factor to risk/returns and should not be avoided but entirely embraced.
For those that want to remain in the capital markets and benefit from any upswings, leverage or deleveraging is an efficient way of automatically reducing your allocation and going into cash. This can be evaluated very much as a return on capital employed function. In a world where negative interest rates may become the norm, this provides an effective solution.
People have tended historically to marry diversification with asset classes. However, you can reduce your asset class exposure and still obtain diversification through ‘factors’. By this we mean, breaking equities down into, say, value and growth as well as size before even looking at geographies.
By allocating to alternatives such as gold and related sectors and by doing this early in a cycle change, we will generally be more prone to benefiting from any upswing in these assets and less prone, having moved assets away from say, equities, to being hit by any major market adjustments. Being cautious doesn’t mean that you will necessarily automatically get poorer returns. The important thing to remember is to be dynamic.
SFOs are a rare breed of investor, able to take advantage of the benefits of both business cycle investing as well as dynamic asset allocation. They are not restricted by investment mandates in the same way a pension fund might be. They should therefore put resources into becoming proficient in asset allocation and understanding both sentiment and business cycles. If this is added to mastering the area of fund selection and diversifying adequately within asset classes rather than between them, then truly they can achieve their objectives ... to create the optimal portfolios without losing capital.