The post-2008 environment of low inflation and low-interest rates has created an illusion of stability, writes Annamaria Koerling
I attended an interview given by Janet Yellen, the former chair of the US Federal Reserve, to mark International Women’s Day recently. The largely female audience gave her a standing ovation in recognition of her achievements and public service.
In her early days as an academic, Yellen did not have an easy time and was not given tenure at Harvard – an environment she said was not at all supportive of women.
I was struck by two things she said: the importance of ‘mentorship’, and her concerns that the new normal of low interest rates and low inflation means that central banks no longer have enough tools to address economic weakness.
This new normal is a problem for many families, and indeed for anyone with savings. The inevitable consequence of lower growth and interest rates is that investors are tempted to take more risk than they would or should in a ‘normal’ situation, seduced by the illusion of stability created by easy money.
Private equity has often replaced a significant proportion of listed equities in the typical family office investment portfolio; in some cases there is also private debt.
Many family offices and the families they represent, fed up with the high fees of ‘blind pools’, are seeking out their own investments. In doing so they are sacrificing not just liquidity but also diversification, and potentially increasing the risks even further.
The approach to allocating a significant proportion of assets to non-traditional asset classes is often referred to as the endowment model of investing, US endowment funds such as Harvard and Yale having invested in this way for more than two decades. Their rationale for this is supported by modern portfolio theory, holding that by sacrificing liquidity and investing in a range of alternative asset classes, this additional diversification can generate superior returns.
This had been the case for the top five endowments in the US, which had consistently outperformed traditional portfolios (typically with 60 per cent in equities and 40 per cent in bonds) by more than 5 per cent per annum over a 20-year period. The past 15 and 10 years have been more challenging and this outperformance has sunk to 2 per cent per annum. However, the average US endowment portfolio has done somewhat worse than this, generating returns on average of 5.2 per cent per annum, no better than the traditional global/equity portfolio returns of 5.3 per cent over the same period.
Despite their long-term time horizon, many endowments found it difficult during the global financial crisis to meet their shorter-term obligations, as distributions and liquidity fell significantly short of predicted levels. Are family offices risking a similar scenario by overcommitting to illiquid investments? The likelihood is that most investors will sacrifice liquidity and increase risk by investing in private assets without generating the hoped-for additional returns.
Family offices should be realistic in their expectations. Simply not investing is not necessarily the solution. Rather, it is important to adopt a rigorous approach and scoring methodology.
One way we tackle this is to develop a scoring system that takes into consideration the risks and other criteria which are relevant to a family’s investment and social objectives, recognising that such investments can have a non-financial role to play as they often engage the next generation and allow family members to pursue their interests.
There may also be a valuable social or environmental contribution which needs to be captured. Here we can develop a risk calibration methodology that is tailored for them, which takes both financial and non-financial factors into consideration. Two factors come to the fore: risk and complexity. While this approach does not eliminate psychological bias, it does enable ‘cherished investments’ to be accommodated in an appropriate way.
Meanwhile, back to mentoring and working with next-generation family members. I had a fascinating meeting in Cambridge with Sucheta Nadkarni of the Wo+Men’s Leadership Initiative at the Judge Business School, where the focus is on equipping young people with the skills and strategies to thrive and progress in the workplace. She said that one of the most popular and effective parts of the programmes they run is when they bring in senior leaders to share their experiences and insights.
Having someone in your life who is prepared to share insights and will give you a positive push when needed can make all the difference. This approach is just as valid in families, where an experienced individual acting as a mentor can play an important role in helping families think through their governance and make and calibrate investment decisions in a more objective way.
Annamaria Koerling is managing partner at Owl Private Office
This article first appeared in issue 68 of Spear’s magazine, available on newsstands now. Click here to buy and subscribe