While have moved away from the perceived precision of

While investing has never been straightforward, investing today in the face of current uncertainty feels overwhelming to many long-term investors.Faced with today’s starting valuations and current yields, many investors have little confidence that the traditional equity/bond portfolio that has generated meaningful returns over the past 30 years will be able to produce the investment returns expected and likely needed by a family to maintain wealth for generations.Amidst the current uncertainly lies opportunity; many families are materially modifying their investment strategies and portfolio goals to more nimbly – and opportunistically – address the new environment. Disruptive trends facing the industry: Rethinking Asset Allocation Many sophisticated investors have moved away from the perceived precision of the mean-variance optimized asset allocation approach and acknowledge its many limitations. An entire investment advisory/consulting industry has, in the past, suggested that defining asset “categories” as asset classes (i.e.: x.xx percent in international equities, and y.yy percent in emerging market bonds), will generate not just a reasonable portfolio, but actually the optimal portfolio, for which no other combination of assets can be expected to provide a higher risk-adjusted return.  Like all quantitative models, a “top down optimized model” is only as good as its assumptions, and thus asset allocation becomes an exercise in forecasting the inputs (expected returns, correlation relationships, and volatility), and applying often arbitrary constraints to push the portfolio to an often predetermined outcome (ie increased allocation to real estate or hedge funds).Leading endowments have been moving away from asset allocation based on asset classes for many years, (footnote: Investment Management and Consulting Association, The Evolution of Asset Classes: Lessons from the Endowment Model, John Mulvey, PhD, and Margaret Holden, PhD, Volume 17, Number 2, 2016).  An article in IMCA from 2016 states that only half of endowments by assets (56%) report asset categories as the current norm (core categories of public equities, private equity, real assets, absolute return and fixed income).  A significant number of endowments are redefining asset categories to better reflect their objectives for the set of investments, with hedge funds leading much of the rethinking, as this disparate set of investments has always been challenging to classify as an “asset class”.  Just as many leading endowments are rethinking the foundational beliefs as to how they construct portfolios, many family offices are similarly rethinking their dependence on a “top down allocation model”.  More and more families say they are building portfolios “bottom up”, based on where they see opportunities, not depending on a quantitative model to guide allocation decisions.One way that some families are evolving their thinking around allocation models is to move to a “goals-based” or “risk-based” allocation framework.  This approach – bucketing investments around a clear objective – helps an investor answer the important questions: “What is this investment supposed to do in my portfolio and how will I know if it is doing it”.   FOX survey data suggests that more than 50% of family offices are using at least some variance of a single pie chart allocation model, and using two or more buckets in their framework.  (GIS Survey data, 2017). The Commoditization of Long-Only Equity ManagementCurrent flows into indexed investments suggest that many investors are rethinking their reliance on active managers to generate potential returns. Coupled with getting the asset allocation “right”, many investors have relied upon active long-only managers to produce “alpha” by selecting stocks that will grow faster than the market, and to manage risk by avoiding potential “loser” stocks or getting out of the market at the right time.  Flow data suggests that the inexorable movement of new assets into indexed investments is continuing – in US equity markets (considered to be a more efficient asset class), and across international markets. FOX family offices confirm this trend.  Within the public equity allocation, (44% of the portfolio), respondents stated that only 51% is in actively managed mutual funds or SMAs.  Most of the rest is managed passively, or holding individual securities.  (GIS Survey data, 2017).The move away from active management is directly related to the overall poor fee-adjusted performance of active managers, relative to indexed benchmarks.  It can certainly be argued that the tremendous increase in valuation-indifferent and “growth-y” passive strategies is a potential risk for equity investors, and others may say that the markets are ripe for active management after a long run of low volatility in many markets.  Nonetheless, investors are voting with their capital, and the move to passive strategies is continuing apace.Not only is the trend away from active management upending the asset management industry, but it is deeply disrupting the wealth advisory industry, as well.   Clients pay investment advisors primarily for two services:  an “optimal” asset allocation, and the suggestion (if non-discretionary) or selection (if discretionary) of mostly active managers within each asset class.  Just as many clients’ have less conviction in the “precision” of an asset allocation model, they are also questioning the need for higher fee active managers relative to the benchmarks, and in many cases, choosing to just “own the benchmark” itself.  Anecdotal evidence also suggests that many investors are moving away from non-discretionary investment “consulting” services, and asking their advisor to take discretion, so that they can better hold them accountable for performance.The movement toward “commoditization” of fund management – where active management is beaten out by simple indexed strategies – is also leading to tremendous fee compression.  As an astute observer of the fund management industry has predicted “Active managers will have a significantly smaller share of a business that is gradually only gradually – and there will be a relentless pressure on fees”.  Source: Laurence B. Siegel, A Prediction for the Future of Active Management – Articles – Advisor Perspectives.  Published January 3, 2017.This leads to a “commoditization spiral”, as the distinctions between fund approaches becomes harder to recognize, low cost funds become even cheaper, active managers have a higher performance hurdle to overcome and cut their own fees: a classic “race to the bottom” in fees. Of course, the trend toward lower fees significantly benefits investors.  However, the overall trend toward commoditization of investment management is also reducing the confidence that investors have in the investment management industry and leading many to move away from the more traditional approaches to oversee their wealth.Reassessment of Hedge FundsHedge funds have generally delivered on the promise of volatility reduction, but have been less successful in delivering strong fee-adjusted returns, particularly since 2008. Many investors sought alpha by investing with smart, nimble managers, as they hoped that the generous fee arrangements would incent exceptional investors to produce strong risk-adjusted returns.  Many have been disappointed and flows to hedge funds have significantly weakened over the past several years.   A recent FOX study found that only 6% of family offices planned to increase their allocation to hedge funds this year, and a resounding 85% did not intend to add capital to hedge funds.The early 2000s saw hedge funds generally providing “equity-like returns, with bond-like risk”.  More recent performance – across an admittedly very disparate asset category – has provided the expected lower volatility, but generated mediocre returns with very high fees. Investors today appear to be looking further afield for “less correlated investments”, as hedge funds face renewed skepticism as to their after-fee (and after-tax) performance.Private Equity as the Panacea?Following the financial crisis, many investors allocated additional capital to private equity funds, seeking higher returns and more tax-efficiency.  Many viewed private equity general partnerships (GPs) as better “aligned” than hedge fund GPs as private equity GPs are only paid their carried interest at the time of the realization of the investment gain (the sale of the underlying business).  While private equity returns have generally been fairly strong (certainly relative to hedge funds), the influx of money flowing into private equity through funds suggests to some investors that private equity is getting crowded. For current vintages, it is clear that private equity firms are buying businesses in a richly priced US equity market.  That may make private equity’s promise -to select and buy good businesses, improve their management, provide more flexible capital, and move the company to attractive exits – harder to achieve.  Given the almost $1 trillion in dry powder among private equity GPs today, it is fair for investors to ask if private equity funds can continue to deliver?Accelerating Interest in Direct Investing in Operating BusinessesGiven the observations above, it may be argued that it is logical that many investors are moving away from the reliance on traditional investments in marketable securities or hedge and private equity funds to generate strong returns.  Instead, investors’ appetite has increased to buy operating businesses or direct real estate, in the hope of better aligning the investment with the time horizon and objectives of the family.Six Drivers of Family Office Interest in Direct InvestingFamilies are attracted to investing directly in operating businesses for both financial and non-financial reasons.Financial return.  Potential return is a significant driver of family offices’ investments directly in operating businesses.  Given the relatively low (some would say unsatisfactory) expected returns across traditional asset categories, investors are seeking investments with a double digit return.  FOX members expect their direct investments to generate an average 14% return (source: FOX Global Investment Survey, 2016).History of building successful operating businesses.  An important distinction between a wealthy family and an institutional investor is that a family has a history of building a successful business (at some point in the family’ history).  In the recent past, families have been “chasing Yale”, seeking to build an “endowment” portfolio based around access to high fee alternative managers.  More families today seem to be recognizing that, even after a partial or full sale of a significant operating business, family members may be able to leverage their depth of expertise in an industry sector/s, and their experience in growing businesses, and possibly create their own “alpha” in the acquisition and oversight of a company.Leverage long term time horizon. While many families continue to pursue private equity from a potential return perspective, some are increasingly frustrated with the traditional fund model. Investors cite various reasons for their frustration but the key challenge seems to be their desire to take a long term view (“buy and hold” vs. “buy and flip”).  Given the paucity of investments that look as if they may be able to create significant but sustainable growth, some investors prefer to bypass the private equity fund model, which typically exits an investment after 5-8 years, and truly hold a solid, growing company “for the long term”.Disintermediating the general partner.  The generous fee arrangement of private equity fund structures – where the GP is typically paid a 2% management fee, and then receives 20% of the carried interest (“profit”) of the business at the time of an exit – has led many investors to ask whether the high fee is justified by the firm’s selection and oversight of the underling businesses.   As it is only “net of fee” returns that an investor receives, some investors are attracted to the idea that they can source and select operating businesses themselves, and thus save themselves the recurring management fees, and capture 100% of the potential capital gain.Next gen engagement / personal satisfaction. Some investors, particularly after the sale of a founding operating business, are frustrated with their “paper portfolio” and would prefer to have more connection to their investments – a building that they can touch, employees and customers. Direct investing can be an effective way to feel more personal connection to a family’s wealth and investments and also to better engage the next generation in business, by having a younger family member sit on a board and have the experience of making a payroll.  Direct investments may be a way for a family to restart the cycle of wealth creation. Desire for impact. Millennials (family members in their 20s and 30s) appear to be more focused on aligning their values with their investments and making investments that are “world positive”.  Investing directly in an “impact” company is often an avenue to seek solid returns, align the values of the family with a company, and also get next generation family members engaged in the investment. ConclusionInvesting today is enormously challenging. As the industry continues to face disruption, families and family offices are joining together to question long-standing approaches, and to find ways to collaborate where they see opportunities.  Family Office Exchange, a membership organization of 380 single family offices, serves as a resource to families as they grapple with these challenges.

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