Family offices are notoriously averse to their assets suffering losses, and, as Edwin Wulfsohn and Rael Berelowitz, directors at Stenham Advisers argue, funds of hedge funds may provide the solution to long-term wealth preservation It is one thing to create wealth, through, say, the sale of a family business. Although this should be liberating, preserving the newly realised wealth is quite another matter. Capital preservation, rather than the risky creation of more wealth, is the mantra of family offices. Such families seek investment advisors who seriously grasp that theirs is a stewardship role for the current and at least the next generation. The three key elements of wealth preservation are understanding and controlling risk, risk and risk.Investment ObjectivesIt has become clichéd to discuss objectives in terms of risk-adjusted returns. Most meetings with families start with an exploration of their return objectives. However, unless there is a thorough understanding of their true risk tolerances it is futile to try to establish return objectivesFamilies mostly say that they are 'risk-averse', but what does this mean? Discussion of risk tends to revolve around volatility. This then leads to a review of the various statistical measures of volatility such as standard deviation and the Sharpe (risk/return) and Sortino (return in relation to downside risk) ratios. These metrics can be difficult for any non-financially orientated family to conceptualise.What is more typical and is usually not clearly articulated is that families are not 'risk-averse' but 'loss-averse' - they usually have low and sometimes zero tolerance for any capital loss.However, to fully appreciate a family's risk appetite, the discussion also needs to relate capital loss to a time frame. Can the family tolerate losses during any 12-month, quarterly or monthly period? They may claim they do have a capacity to handle a capital loss for up to three months. A single quarter sounds a short period. It is 90 sleepless nights that can result in anxious calls from the family to their advisors.The 2000 bear market in equities lasted over two years - many sleepless nights for those with any, let alone those with excess exposure, to long equities. Research into behavioural finance indicates that the pain investors suffer when they lose capital can be up to three times the pleasure of making profits.For an average family, the more relevant measures of capital loss are a high percentage of positive months (over 75%), small draw downs especially during stress periods and the five-year compound annual return. It is simple - if the fund makes a profit, capital is preserved.History can tell us so much. However, predicting the future of markets and uncertain events is risky. As wealthy clients tend not to want to carry market-timing risk, absolute-return strategies need to become a core asset class of the family's portfolio.Is history repeating?Since the 1990s, family office portfolios were built on two pillars:nWealth preservationnSome growth to secure the financial security of future generationsInflation rarely featured in their objectives. Inflation indices in the West mostly measure the cost of a pair of socks made in China and a potato subsidised by the EU CAP. However, more recently the wealthy have learnt that there is real inflation in what they spend their wealth on, mostly services - private education, medicine, hotels, restaurants, opera, lawyers, nannies and also wine, art, fast cars, residential property and divorce. It's never been so expensive to be rich. Even for the average person, real inflation may be back with a vengeance - transport, mortgage interest, council tax, utilities. UK inflation is at its highest rate for 15 years.So, will history repeat itself? The investment objective of the 1970s and 1980s is being resuscitated by the new old paradigm - "inflation-djusted" capital preservation.However, despite an increasingly inflationary environment, investment advisors need the courage to prevent families from being tempted to invest in risky asset classes in the hope of achieving high returns to compensate for inflation.Whatever return objective is chosen by the family, it usually concludes in a mandate to deliver consistent absolute monthly, or at least quarterly, positive returns.Role of FOHFsBecause of the difficulty of market-timing and their real fear of capital loss, family offices have over the years allocated an increasing proportion of their portfolios to FoHFs. Interestingly, FoHFs have also recently gained greater acceptance from pension funds, who are perceived to be the most conservative of investors.The reputation of FoHFs was significantly reinforced by their ability to deliver strong positive returns during the 2000-2002 bear market and the stress test of 11 September 2001. In a portfolio broadly diversified by asset classes, FoHFs provide an anchor and smooth returns to reduce overall volatility.Recently, there has been much press about underperformance of FoHFs relative to equities. This is an inappropriate comparison. FoHFs play an entirely different role in a portfolio, occupying a lower risk/return profile in the asset allocation model illustrated right.Historically, the wealthy invested directly in single hedge funds to generate outperformance against most other asset classes. However, this resulted in concentrated manager risk. So, increasingly, loss-averse families moved down the risk scale into diversified FoHFs. These are now viewed as the cornerstone of any portfolio for family offices or for liability-driven institutions, such as charities, endowments or pension funds.Power of compoundingMuch of the 'new' money pouring into FoHFs over the last few years has come from 'old' money and pension funds deeply scarred by the ravages of the 2000-2002 bear market. The consequences of the capital losses suffered from their equity exposure is evidenced by the huge pension fund deficits. For example, a 100% return is needed to recover from a 50% loss. Assuming a 9% compound annual return, it will take eight years to recoup the loss excluding the opportunity cost of the lost income over the 8 years. The chart above illustrates the power of compounding using low volatility FoHFs.However for inflation, pension funds might as well have held their funds in cash because of the power of compounding. Based on their historical performance, low-volatility FoHFs will achieve inflation-adjusted returns.appropriate SelectionThe core investment objectives usually are:nAchieving inflation-adjusted returns uncorrelated with equities and bonds of, say, 3%-5% above the risk-free returnnAvoiding capital losses in any single quarterThere is a large universe of FoHFs so when selecting one, the main risk and return parameters should include:Ability to deliver consistent absolute returns in all market environmentsDiversification is key to risk management and is the heart of portfolio construction. It includes diversification by:a)Strategy and styleb)Managerc)GeographyUnderstanding and controlling risk in hedge funds should be informed by thorough quantitative and qualitative research. It is more important to worry about how much a manager could lose than how much he could make.Quantitative researchThe quantitative analysis should comprise:nTop-down/bottom-up selectionnDisciplined investment processnRigorous analysis and research into strategies, styles and managersQuantitative research is fundamental, but, by definition, it is backward-facing.Strategy selection and qualitative researchQualitative research includes selecting those strategies and managers likely to respond positively to changing market scenarios. This forward-looking qualitative overlay is one of the most important value-added functions of a successful FoHF, using research and deep sector knowledge to anticipate and avoid potential problems in certain strategies, while positioning the fund to capitalise on new opportunities as they emerge.For example, it is key to avoid investing in those strategies that may not prosper in certain conditions, such as convertible arbitrage strategies in 2005, and to select those that were more likely to succeed, for example, distressed debt at the start of the recession in 2002.The portfolio needs to include strategies and managers that are positively correlated to bull markets but negatively correlated to bear markets.Manager selection/monitoringThe role of the FoHF is to select disciplined managers and, through monitoring, to ensure that they stay disciplined.FoHFs must demonstrate they have well-tested and robust selection and monitoring processes. Due diligence on operational risk is as important as investment risk.Regular analysis of performance - relative, absolute and attribution - is vital.LeverageLeverage accentuates returns and drawdowns. So it is advisable for loss-averse families to avoid strategies and managers who employ excessive leverage. Leverage can be particularly dangerous in complex and illiquid strategies and was a contributing factor in the downfall of Amaranth.CorrelationCorrelation and non-correlation are integral to enhancing returns in a bull market and mitigating losses in extreme conditions. There is no substitute for a long track record of seeing how strategies and managers are correlated to real-time exposure in different environments.current concernsThe sheer volume of money pouring into the sector understandably raises concerns about the ability of hedge funds to absorb the growth. There are issues - liquidity, leverage, capacity, transparency and fees. It is the role of the disciplined FoHFs with long, demonstrable track records (as opposed to pro forma performance) to avoid these problems. This more than justifies their fees.For family offices and institutions, many of these issues can be overcome through customising portfolios of hedge funds in segregated accounts to meet specific risk return objectives or to replicate the house flagship FoHF.ConclusionThe case for FoHFs has been widely made. They have been proved to:nMinimise the risk of capital lossnDeliver stable absolute inflation-adjusted monthly returnsnOffer downside protection in extreme market conditionsnBring diversification by strategy, manager and territorynProvide low correlation with other asset classesnAvoid market-timing anxiety.FoHFs have become the foundation of any portfolio where the family are loss-averse or where the institution is liability-driven. For investment advisors whose role it is to be the custodian of the family estate and where financial security for follow-on generations is a core objective, the logic of investing in FoHFs is compelling.Once family offices come to understand the real risks inherent in their investments, they rightly demand exacting standards from those tasked with the stewardship of their fortune. At the very least, they expect a rigorous qualitative and quantitative methodology for their portfolio construction.Avoiding capital loss, together with the power of compounding, provide a strong argument for family offices and their professional advisors to include FoHFs as a core element in their portfolios, to enhance their wealth over the long term....
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