Does the manager’s philosophy seem sound and do you understand it?A FAMILY SHOULD DESIGN ITS INVESTMENT POLICIES, PROCESSES, and disciplines strategically to meet the family’s goals and objectives. The challenge again is achieving the perspective necessary to see the destination before selecting the route to get there. Every element of investment theory, policy, and analytics should work together to make the wealth do what it is intended to do by helping the wealth holder accomplish his or her purposes.
We could examine individually and separately each of the elements we review in this chapter—performance measurement, volatility, transparency, asset allocation, diversification, investment styles, due diligence, and investment education; however, ultimately they must all be harmonized if they are to promote the purposes together. A family might examine each alone in terms of wealth preservation or wealth creation, but wealth is never for preservation or creation. Wealth is created or preserved to accomplish a specific purpose.
The success of an investment program is measured by its appropriateness to accomplishing its purposes, and, from this perspective, private wealth investment programs must be quite different from institutional investment programs. Compared to private wealth goals, institutional purposes are more consistent, pension fund to pension fund, endowment to endowment, or institution to institution, and measurement of the appropriateness of the investment program of an institution is much better suited to analytic tools. The vocabulary, the evaluation, and the implementation of private wealth management programs are strategically different from those of institutions. This is because whether the investment program is “appropriate to accomplishing purposes” is necessarily different when dealing with private wealth holders. Although many of the topics and tools in the investment manager portfolio are standard solutions that look identically applicable to all investors, whether institutions or private wealth holders, few really are.
Let us look at several common ways in which private wealth and institutional wealth require completely different investment considerations. A family may design some portfolios for purely education or training purposes. Frequently, a private wealth holder will say that he or she wants a fund for “fun,” whether high-stake risk, consumption, or acquisition of artwork. Taxation may be different for a private wealth holder so that the return produced by an investment may be different from gross return after taxes are taken into account. Time horizons will affect performance analysis, and the time horizon for legacy wealth is likely to be much longer than for institutional wealth.
As much as what is appropriate for an institution is not necessarily appropriate for a private wealth holder, what is appropriate for one private wealth holder is not necessarily appropriate for another. What the wealth is to accomplish, its purposes, varies from individual to individual. From those variations in purpose must follow variations in investment programs.
Returning to the foundation described in Chapter 6—which was strategically designed to be unbundled and, which after a while, was voluntarily bundled by the children of the creator—we had reached the point where family members, having pooled their grant-making and related activities, wanted to start to understand the investment of the endowment. The endowment had been managed by a bank. The foundation called a meeting for an analysis of the investment portfolio. Rather than starting with analytics of asset allocation and performance, we started with a review of the grant-making history of the foundation; areas of concentration were women, immigrants, and Jewish projects. But what does that have to do with investment? The answer quickly came with the review of industry weighting—double weight in oil companies. The oil stocks had done well, but were they consistent with the purposes and culture of the foundation?
The family moved from this conversation into designing a process to find investment managers who shared vision and views with family members. The proposition was that harmony of investment and goals is as important as investment return and that the foundation should reflect the values of the family members. Over a year, the foundation hired six or seven managers of different styles, mandates, and expectations but all sharing life views and principles with the family members. In this way, the foundation developed a harmony between its purposes and the investments.
When we consider investment performance we often consider return, that is, what percentage increase or decrease has occurred over the relevant time frame. The higher the increase, the greater the return. That is easy to measure mathematically. But any performance to be considered is only partly return; it is also appropriateness. For the pension or annuity fund, for the endowment fund, appropriateness takes into account the elements of risk and the requirements of return. For the private wealth holder, appropriateness takes into account whether the investments are appropriate in terms of what the wealth is for.
Appropriateness and dollar return may be completely different. A client created a charitable lead trust for his grandchild and future generations while the grandchild was an infant. Ten years after the grandfather created the trust, he and his son, the father of the child, ended up with no relationship with the child. Tragically, the mother had taken the child out of the country and he was completely estranged from his father. With no connection to his grandchild, the trust creator wanted to terminate the trust, but that was impossible. He was a very smart investor and asked me how he could take away the value of the trust from his grandchild and his grandchild’s descendants. I asked him to name the worst investment he could imagine and he said that would be bonds. Bonds were a perfectly legal investment for a trustee, so the trustee built a portfolio entirely of long-term bonds, which has lost relative value over the 25 years since. The investment return of that trust looks terrible; the investment performance is just right!
Measuring performance is not easy if performance is defined as encompassing appropriateness. Technology can easily measure return on a portfolio and may even measure risk in a meaningful way. For a private wealth holder, when risk is only a part of appropriateness, many subjective considerations that cannot easily be measured may be applied.
That point was illustrated by one Hong Kong family that decided its investments should reflect family culture and values. Each portfolio, the family decided, should be evaluated in terms of its effect on a community and its reflection of the family’s view of its role in the world. That seems a laudable standard for performance and clearly reflects a shared vision of what the wealth is for. However, the family is facing a challenge it will have trouble meeting—developing metrics and evaluative tools to reflect the performance taking into account family values. The definition of performance for that family is sound and wise; the desire to develop objective tools to measure the subjective standards may in fact be too ambitious.
It is difficult to measure return unless there has been a strategic analysis of the purposes of the wealth. Shall return be measured in terms of U.S. dollars as if none of the uses for the wealth may be outside that currency? Should non-U.S. residency, travel, investment, and philanthropy be disregarded in measuring performance?
I was reminded about the strategic value of managing currency risk by an experience I had in the late 1970s. A U.S. resident, I decided to invest in some Japanese stocks, while at the same time a Japanese friend decided to invest in some U.S. stocks. Several years later, the S&P 500 Index was up dramatically, the Nikkei 225 had been stagnant, and the dollar had slumped considerably against the yen. My Japanese friend reported that his investments in the U.S. stocks had been lackluster; however, I found that my Japanese investments had soared. Measuring return in yen produced a quite different result from measuring return in dollars.
Almost any wealth creator has faced substantial volatility during the creation of wealth. And long-term wealth preservation has encountered the vicissitudes of markets as they go through depression and recession. Mechanical tools for implementing and guiding standard models of strategy attempt to collar volatility but are not always perfect.
Technology and analytics have developed “Monte Carlo” programs to measure and test risk tolerance. They are relatively easy to use, and they create enough data that most users feel the comfort of process and technology, even if they do not quite understand what the data mean. The programs give the advisor a complete booklet and easy tools for communication. All in all, the computer gives a standard analysis that sets forth the “reasonable” terms of tolerance for volatility.
But consider some of the faulty assumptions and conclusions that can occur with these kinds of programs. Reducing volatility through utilization of derivative products and funds of funds may or may not work. The assumption that there can be fail-safe, absolute return strategies will continue to prove erroneous. And many would consider lack of transparency risky, but that risk is not measured.
Several individuals in a family of wealth created early in the past century and enhanced over 80 years of investing in common stocks had moved from a traditional large-cap growth manager to a more “modern” manager of managers and developer of funds of funds. Over two or three years, Monte Carlo exercises had moved them into funds of funds and lowered expected volatility. With the realization that tax reporting would be delayed because of the complexity of the funds of funds, the family members began to feel uncomfortable. In essence, the lack of transparency was bothersome. Analyzing their goals as long term and their objective as feeling comfortable with their wealth, they determined that they really did not mind volatility and made the strategic decision to move out of funds of funds and back into portfolios of common stocks, diversified as to style and manager. Shortly after moving out of the less volatile funds, the portfolios went through the downward plunges of 2008; their owners were not fazed or worried. They were comfortable with the decision they had made and the resulting portfolios.
Indeed these individuals concluded that volatility was not bad. Others cannot tolerate any volatility and should consider portfolios that are fixed somehow in value (not easy but clearly a sound objective to try to accomplish). The reasonable conclusion is that there can be no “standard” evaluation of appropriateness with respect to volatility. The technology available for these purposes is not complete since it cannot have the conversation to ascertain feelings about volatility.
Like volatility, transparency requires individualized consideration. Opaqueness may be appropriate in some situations and not in others. Consideration must always begin with analysis of how transparency or opaqueness strategically furthers the purpose of the wealth.
Definitions of transparency are already somewhat confused, so before evaluating whether transparency is desired, it is useful to define it. A banker assured me that his bank’s proprietary fund of funds was “fully transparent.” Did that mean that as a trustee owning that fund of funds I could know what the various managers held? He explained that I could not know that, though I could know that his bank put the fund of funds together. Then perhaps the bank could tell me what the underlying managers owned; but no one at the bank knew the names of the various underlying funds. Each fund manager knew what he owned, I was told. Transparency? The banker replied: “It is derivative transparency.”
Regardless of the definition, investment transparency has not been required through most of modern times. Most customers have been willing to live with opaqueness over the past decade—look at the chicanery nicely hidden in Lehman, AIG, Madoff, and others. The current insistence on transparency is partially a reaction to the widely publicized frauds of 2008 and 2009 but will take considerable effort to maintain in a world of derivatives, private equity, and alternative investments.
As a strategic matter, transparency should be viewed as inherently neither good nor bad. Instead it should be seen as an element of process. Can the process being developed so that wealth serves its purpose also be consistent with funds, strategies, and other investments that cannot be understood or independently evaluated because they are not transparent? Are hidden fees and charges acceptable in making the wealth accomplish its purpose?
If wealth is for comfort and helping future generations be functional and free from the burdens of wealth, there must be an underlying assumption that the wealth holder can understand what is happening and how profits are being made whether or not he or she decides to do so. It is human nature to want to feel that we can understand what others are doing for us, even if we do not want to do it for ourselves. We educate our children to know how to use a sophisticated calculator, even though we may not expect them in adulthood to be engineers. We know enough to understand the auto mechanic as he describes the repairs that must be made even if we cannot make the repairs ourselves.
So if wealth is multigenerational and about functionality, transparency becomes important. If it is instead about control or protection, transparency may not be so important if the trustees and other stewards can evaluate investments adequately without transparency.
A strategy governing asset allocation is particularly important because the primacy of the asset allocation is one of the fundamental tenets of the wealth management industry. A poorly managed asset allocation strategy can lead to disaster. Conventional investment wisdom is that asset allocation plays a substantial role in determining investment performance. If we measure performance by appropriateness as well as return, we must consider asset allocation strategically and as reflective of appropriateness for the wealth holder.
There is an assumption in the wealth management industry that there exists an ideal asset allocation that can then be tweaked through a Monte Carlo simulation. In other words, what makes sense for the large pension or superannuation fund will make sense for most private wealth holders.
That assumption is almost always wrong. Any well-run pension fund or institution starts by looking at obligations and reserves. Before there can be any consideration of asset allocation, individuals must analyze what they need where to make the wealth do for them what they want it to do. Careful plotting of cash needs should be built into a piece of the portfolio, and that piece should be seen as free of any consideration of asset allocation—that is, free of the constraints of percentages in cash and fixed income.
If community is part of the purpose of wealth, it would not be unreasonable for a wealth holder to set aside a portion of a portfolio in clear liquidity to be used for charitable or private gifts, private investments in socially worthwhile projects or a friend’s venture, or merely as “play money.” All of this must be removed from the pool subject to asset allocation before any discussion of allocation can take place.
Consider a charitable lead annuity trust, a trust that has a fixed obligation to pay a fixed dollar annuity to charity for 30 years. In its earliest years, before there has been appreciation adequate to assure the annuity can be paid, the reasonable trustee will build a laddered reserve of bonds designed to pay the annuity for some reasonable term. The balance of the portfolio can then be subject to an asset allocation exercise.
Strategic design of a portfolio thus starts long before asset allocation. And it starts with understanding goals.
It may also start with understanding where the wealth has come from. Wealth coming from 80 years of a common stock portfolio should not move too rapidly out of that portfolio if comfort and legacy are to be considered. And wealth coming from 80 years of real estate should not move too quickly into common stock. That means at a given time, a portfolio of 90 percent equities can make sense for one person while a portfolio of 10 percent equities can make sense for another. Neither percentage comes from a hard-and-fast rule that should apply to every investor. Each reflects a notion of appropriateness designed for the particular investor.
The importance of diversification is seen as comparable to the importance of asset allocation in any traditional analysis of an investment portfolio. Most investment experts see diversification as sound investment strategy, protecting against risk in almost all circumstances. Indeed, diversification can protect against some risks in all circumstances if it is broadly defined to include not only diversification of asset class but also diversification of currency, custodians, jurisdictions, liquidity, managers, and lifestyle capacity, all as we discuss in the following pages.
Diversification is commonly defined as spreading investment portfolios over many asset classes and many styles. But broadening that definition may be desirable in any strategic analysis. If the goal of diversification is protection against external risks, market risk is only one of those. A simple definition that includes only asset classes and styles limits the protective capacity of true diversification. Diversifying asset classes even among stocks and bonds is, of course, protective. But protection is enhanced when diversification is broadened to include different types of stocks and different kinds of bonds. Further protection can come with developing strategies to own assets other than stocks and bonds. Risks of custody, geopolitical developments, swindlers, and other factors can also be minimized through different forms of diversification.
Generally, wealth creators are not diversified during their creative period. As a general proposition, a great fortune is built on a great company. There are exceptions in conglomerates, such as Berkshire Hathaway and in the financial services business, but the world is filled with very wealthy individuals and families who built their wealth as did the Gates family, on one company in one jurisdiction. It is no surprise that diversification frequently begins when another generation comes on and decides to protect the wealth. Wealth creation is never a purpose for wealth, but until the wealth is there, its creation is the natural inclination. Once the wealth exists, its purpose is more likely to be accomplished through preservation. Diversification is the hallmark of preservation.
A wealth holder may have a “core holding,” a particular stock or other asset that represents a substantial part of the portfolio and may have been the source of the wealth. The starting question is whether diversification out of a core holding is strategic. In some cases, there can be more financial success without diversification. There are those of great wealth who do not diversify. There are businesses that stay in families for generations and provide wealth to family members for even longer.
A patriarch sold his gas stations to Standard Oil, and 60 years later his heirs continue to hold Standard Oil (now BP) as a substantial part of their portfolio (until recently almost 80 percent) notwithstanding advisors urging them to diversify. Ask why they have held on so long and the answer is a kind of guilty, “We just don’t want to sell. We know it is not smart, but that is what we want.” Keeping the stock gave the family comfort even many years after the patriarch’s death. In fact, the family believed that with hundreds of millions of dollars in the company, the stock price could fall by half and the family would still have plenty. They felt they would never be uncomfortable holding the shares they had inherited.
Then came the Gulf of Mexico oil spill in the spring of 2010, and the BP shares started to plummet. With anxiety and great distress making the decision, the family sold the entire position. There followed a kind of quiet peace. The family had indeed lost something like half the wealth, but what was left was adequate for all the family’s purposes and was worth exponentially more than the Standard Oil stock the patriarch received when he sold his gas stations. Importantly, unlike many families holding failing businesses, the family realized the importance of selling the BP stock before the loss might be complete.
The world is full of stories where the families are not quite as fortunate. Look at any failed company and you are sure to find shareholders who lost their wealth. Many family members are sunk in the process of holding a family business. I watched two trusts established at the same time, each directing that the trust estate hold the shares of the company given to the trust and not diversify. At creation, each trust was worth $2 million. Holding publicly traded shares of a family company, one was worth nothing 20 years later—the company had gone bankrupt. Holding publicly traded shares of a widely held company, the other was worth $60 million 20 years later. In either case, with complete diversification the trust would have been worth somewhat less than $60 million and somewhat more than zero.
There may be other reasons not to diversify out of the core holding. A reasonable analysis of what the wealth is for may include an interrelationship of family, business, and community. If that is what the wealth is for, diversification may be protective but may not be strategic. Consider the handful of family businesses worldwide that are in the fourth, fifth, or sixth generation and how strategy would have been foiled if the business had been sold in its first generation. Those family businesses, whether Ford, Cargill, Johnson Wax, or Rothschild, define the family and their communities. Retention of the business without diversification is strategically central to that definition.
Where the decision has been made that diversification will help the wealth do what it is for, the next strategic consideration will be in what ways to diversify. Each case will require its own definition of diversification.
There was a time when nearly every U.S. investor said that diversification meant a portfolio of U.S. large-capitalization stocks and bonds, possibly with a little real estate thrown in. Today, that view would be seen as old-fashioned. Indeed at last count, experts were bandying 30 or more asset classes required for diversification.
There used to be an interesting difference between the way the Fung family and the Fisher family invested, according to public accounts. The Fung family, based in Hong Kong, built its wealth sourcing plants in China for retailers and others looking to China for manufacture. The Gap, owned by the Fisher family, was one of those retailers utilizing the Fung operation. The Fungs wanted to invest in the United States. The Fishers wanted to invest in China. The Fishers built a portfolio of publicly traded companies, none of which were in the manufacturing business, to diversify their base. The Fungs built a U.S. investment banking operation looking for investments to be made in U.S. retailers in which the Fungs could help build value by using their understanding of manufacturing. Either approach is a kind of diversification. Neither is clearly correct and neither is clearly wrong. Both are clearly strategic, and both are efforts to diversify with respect to a core holding.
Defining diversification requires careful consideration of the wealth holder, his or her goals, and his or her situation. Stocks and bonds are adequate for many people. However, let’s look at a number of areas where the sophisticated investor, particularly one attuned to globalism, might demand diversification beyond even asset classes.
We have touched on diversification of asset class—stocks, bonds, and cash equivalents—and will touch on it again when we discuss investment styles later in the chapter. This type of diversification is well accepted in investment theory, and volumes have been written on the subject. Selection of asset classes and allocation to those classes must be strategic in all respects to accomplish the wealth holder’s purposes.
Most asset allocation models have a category of “cash” and most statements categorize short-term obligations and money market funds as “cash.” Indeed, when an individual is designing a portfolio, he or she must start by building into it his or her cash needs.
But in today’s world, we must start by asking, what is cash? Cash is fundamentally currency, and deciding what currency or currencies should be seen as “cash” requires strategic analysis of needs and purposes. An individual based in the United States would likely consider the U.S. dollar cash and the Thai baht a speculative investment. Would the Thai resident apply the same analysis? And what should a family with residents in both the United States and Thailand treat as cash?
For a family living in different jurisdictions around the world, cash is something different for each jurisdiction. It can be U.S. dollars for the U.S. person, sterling for the British resident, euros for the French resident, yen for the Japanese, and so on. In a world of wildly fluctuating exchange rates, there can be no “standard” currency for such a family. For those families with members residing around the world, a cash portfolio must be designed around the members in the various “currency jurisdictions.”
Similar considerations of strategy should be applied to the family that resides in only one jurisdiction. Suppose we have a fully U.S.-based individual. That individual may travel overseas or may have assets and investments outside the United States, possibly mortgaged by debts in non-U.S. currency. The individual may have private equity commitments in currencies other than the dollar; and he or she may have philanthropic initiatives outside the United States that must be funded in currencies other than the dollar. The individual (or the individual’s family) is no less likely to suffer loss in fluctuating currencies than the family with globally diverse residencies.
Once the currency is set, how to hold it may remain a problem. We have seen money markets “break the buck” as they become worth less than they are stated. We have seen “almost cash” auction rate securities locked away and not accessible. In some currencies, such as the U.S. dollar, bonds (such as treasury obligations) are in fact cash; in others, such as the euro, the money printers do not offer debt.
So even after the wealth holder determines what he or she needs in cash, defining it and figuring out how to have it are both difficult.
The banking crisis of 2008 left many wealth holders asking whether reliance on one custodian was in fact wise. If cash must be diversified, logistically the securing and placement of it must be diversified. If Lehman and AIG, and other giants “too big to fail,” could approach or enter bankruptcy, was it truly wise to have all eggs in one bank?
Some wise businesspeople may say their lending bank wants more business, so they will send it some custodial work. That is an appropriate business decision—strategic from a business standpoint. It may also be a wise investment decision to use several other custodians as well, particularly if the lending bank is small and not likely to be “too big to fail.”
In considering custodians, a wealth holder must apply due diligence to determine the distinctions among custodians based on business organization, business model, and jurisdiction of incorporation. The old belief that banks are safer than brokers may be misplaced in a world where banks are brokers and brokers are banks; structural and auditing differences can exist between two companies in the same business so that in fact Schwab may be quite different from Fidelity with respect to security of assets held. Even after the due diligence is finished, the conclusions will not be clear. Then it becomes reasonable to have several custodians to protect against failure of one.
In diversifying custodians, it may seem logical to limit oneself to custodians in one’s own jurisdiction, particularly if that jurisdiction is the United States. If that jurisdiction is South Africa, or India, or Indonesia, or many other countries, the limitation would seem unreasonable if you can foresee political instability or feel uncertain that you can locate several responsible banks in the country. In light of the developments of the past years, some wealth holders are saying it is unreasonable to use Switzerland as one’s only jurisdiction. And if it is reasonable to diversify beyond Switzerland, is it not also reasonable to diversify beyond the United States?
The point is that real diversification may also require diversification of jurisdictions. If cash is to have diverse jurisdictions, custody must follow the cash. If a family holds real estate outside its home jurisdiction—for example, the French in South America—should they not diversify jurisdiction with respect to all elements of their wealth? If currency controls reenter the world’s economic policies, should one place all of one’s affairs in just one country? The answer most likely is no.
Are equities truly diversified if they are all traded on the exchanges of only one jurisdiction? If oil is to be part of a portfolio, is it reasonable to hold interests only in the United States, or might one look at Eastern Europe and the Middle East and ownership in more than one? Should gold be held in several jurisdictions?
The world’s refugees, whether from the Holocaust countries, South Africa, China, or elsewhere, know how important it is to find a secure jurisdiction. Any Indian who lived through the years of India’s tightly controlled economy knows the rewards of having business outside India. Those who left China in the 1940s know that ownership of real estate in Hong Kong provided economic freedom. Today, refugees or individuals who believe they may be refugees in coming years are concluding that one jurisdiction is not enough. Many wise investors are using custodians in different jurisdictions, looking at market exchanges in different jurisdictions, and considering asset location in different jurisdictions. If Iceland and Ireland and Greece can stumble, might not other countries disappoint?
To have truly diversified liquidity requires a diversified perspective on currency and a diversified perspective on custody. But defining diversification of liquidity will also require strategic analysis in other areas as well. Those who relied on auction rate securities as their portfolio of liquidity were disappointed. Those who relied on Lehman custody for liquidity outside the United States were also disappointed. Greek bonds have proven not as liquid in euro terms as the bonds of a country actually printing the currency will appear in terms of that currency. Gold is liquid only as long as it is held in an accessible place, only as long as you can withdraw and use it.
There are two gold stories that illustrate this point. One investor placed his gold in safe-deposit boxes around the world. His theory was that wherever he happened to be, he could access some of his gold. That will prove sound so long as the safe-deposit boxes remain open.
Another investor designed a “gold fund” with certificates that could be redeemed for gold in banks around the world. The fund looked solid until Lehman entered bankruptcy—Lehman was a counterparty central to the entire arrangement. “Who would have guessed that Lehman would go bankrupt?” lamented the investor.
Theoretically, diversification of asset class, jurisdiction, and liquidity is most effectively accomplished by diversifying investment managers. Let each manager have its own investment mandate based on asset type, style, and jurisdiction. Diversification of managers now seems well-accepted policy. Indeed any consideration of the history of investment management companies must recognize that there has always been a sense of specialization of analysts within each.
Whether and how a private wealth holder diversifies managers must be considered strategically. It is not easy to diversify managers without a sound due diligence process to analyze the managers individually and in relationship to each other. One must consider the following questions:
Does the manager’s philosophy seem sound and do you understand it?
Is the manager’s operation and history consistent with that philosophy or style?
Does the manager do what it says it does?
Are the manager’s benchmarks reasonable?
Will the manager understand the wealth holder well enough to customize his or her portfolio to meet that individual’s needs?
How do the manager’s portfolios relate to one another?
This last point is particularly complex. It is easy to have one manager buying while another is selling or one manager hedging while another is buying. Many investors found that a number of their managers, even those of different styles, were holding the same securities, such as AIG or Enron, or utilizing the same counterparty, such as Lehman. Indeed, it may be that one investment manager can provide more diversification and less concentration than multiple managers if that manager is attentive to the needs for diversification and has sound internal due diligence process.
Effective diversification of managers requires hard work, transparency, and complete understanding of manager after manager. Substantial due diligence infrastructure must be in place if one is to gain strategic benefit from diversifying managers. Is the wealth holder willing to invest the time and effort to build or secure that infrastructure? Does the wealth holder have the capacity to insist on full transparency? If the infrastructure is to be outsourced, is the wealth holder willing to invest the time and effort in evaluating managers of managers or consultants, and are the “industrial-strength” consultants actually available?
These questions cannot be answered abstractly. Strategic considerations are central to determining the responses appropriate for each individual. Is the wealth really “for” the kind of hard busywork necessary to answer those questions? There are no shortcuts. Family after family has had to ask one of its members to devote years of his or her life to building or securing the infrastructure necessary for due diligence. Is diversification of managers worth the loss of time and the impediments to self-actualization?
For most wealth holders the sacrifices necessary to build due diligence are not worth the loss of time. A well-designed family office may be a solution. “Outsourcing” to consultants may be a solution. Many have solved the challenge of diversifying among several managers by hiring one manager who is good and has a diversified approach to investing.
Some of the wisest wealth holders have what may be termed a refugee mentality. Most are refugees who have escaped Hitler’s Germany, Mao’s China, South Africa, Rhodesia, Iraq, and elsewhere. Ask these wealth holders what wealth is for and most will answer clearly: Wealth is for protection and freedom to move wherever and whenever the need arises. If that is what the wealth is for, strategic thinking leads to diversification relating to where to root one’s life: passports, homes, languages, and associations.
A refugee whose family escaped Hitler and who now lives in Switzerland has great wisdom. He is diversified in the most complete and traditional ways with respect to asset classes, jurisdiction, cash, liquidity, and managers. His children have been educated so they have associations and friends throughout the world—contacts to connect with regardless of what is happening in one part of the world or another. He owns seven or eight hotels around the world, each with an apartment that is his own, so that he can live anyplace in the world. Ask him whether these hotels are good investments and he will answer that they are “the best” because they guarantee him the freedom to move easily and at any time. In effect, he has strategically diversified those places he can live comfortably. He has a diversification of residences.
Different investors have different investment styles. Here we are not talking about diversification of those styles (which often makes sense) but rather selection of a style that makes sense for you. Fundamentally, investments must make sense to the investor not in every detail but in assumptions about the world. Consideration of investment style requires a worldview.
This goes well beyond the analytic strategy necessary to find the “optimal” mix of styles for greatest returns or matching of risk tolerance accomplished through so-called Monte Carlo exercises.
Individuals’ understanding of the world around them and how they relate to it becomes a key ingredient in any strategic consideration of investment style.
The fact that even a wealth holder without expertise in investment theory can make observations that help guide investment portfolio and styles can be illustrated with many examples of successful stock picking. For instance, a friend of mine was an early investor in Minnesota Mining because his wife liked Scotch tape. Another friend had a background in retailing and sourcing hardware and invested early in Home Depot. Doctors were some of the early investors in Amgen. In each case, everyday or professional experiences informed a view on which companies had good prospects.
Broader investment issues can be answered by the nonprofessional based on personal perspective. Questions like this are asked by clients and answered by professionals in many investment reviews: “Will health-care control affect drug stocks?” “Is the United States going to continue to be a world leader?” “Are United States auto companies as good as Japanese auto companies?” In fact, anybody reading a newspaper can answer those questions with as much expertise as a Ph.D. in economics. In that way, an investor can help shape his or her own portfolio of stocks.
Should an investor be a “value” or “growth” investor? A value investor looks for companies or opportunities he or she believes are undervalued in the market. A growth investor looks for companies or opportunities that have performed well in the past and that the investor believes will continue to do well in the future. If well articulated, the distinctions between value investing and growth investing aren’t so hard to understand. “Do we look for the dark horse or do we find a horse riding well and jump on?” That is the way one investment professional told it to me some 30 years ago. And as inexpert as I was, I could express an opinion.
Other investment questions can similarly be addressed based on logic and experience. “Will the world continue to develop with fewer and fewer boundaries and with more and more transportation; and will the United States always remain on top?” If the answer is yes to the first and no to the second, a global portfolio is appropriate. “Are there indices that will measure what I need to make my wealth do what it is for?” If so, passive investments may be appropriate. “Am I looking for good stories to make investment performance comprehensible?” If so, passive investments are not appropriate.
Investment styles must also be reflections of a wealth holder’s purposes. I recently heard of an arms dealer who collects and invests in textiles. Although I have not met the gentleman, I am willing to wager that his alter ego needs the investment in soft goods of beauty.
The Chinese family that wants to measure performance by impact on the community and by more than return probably should be looking at investment styles different from those of the Texas family whose wealth has been built in the oil industry. The family whose wealth comes from banking or investment services is likely to look at investment styles different from those whose wealth was built on real estate. A good bond manager is probably crucial for the family that is most comfortable in fixed income and not even worth considering by the family that is most comfortable with volatility. Consider again the different investment styles and strategies employed by the Fung and Fisher families mentioned earlier in the chapter.
A wealth inheritor “of the old school” sent his sons to the boarding school he had attended in Massachusetts. He got his sons into his alma mater college and pounded “old-fashioned” values into them. They were to be in his mold and in his image, one that went back three generations to his great-grandfather, who built the wealth and invested in stocks and bonds through most of the twentieth century. Yet, at the first trust meeting his sons attended, the father introduced young Wall Street men who were talking alternatives, derivatives, and other “cutting-edge” investments. Strategies were hedged, derivatives related to mortgages on stretched consumers, and one fund was invested with Madoff. Was this a strategic investment program? Did it forward the purposes and values the father was trying to instill? Probably not. If the father had been one of the pioneers of the computer industry, if his culture was new ideas and he was trying to instill creativity, the session may have been appropriate. Transparency, liquidity, and complexity should not have been the standards in this investment design; values, tried and true, patience, and perseverance were the values to be encouraged. They were not.
If wealth is about freedom, convoluted investment strategies are rarely strategic. There can be no process, little delegatable, and no likelihood that the wealth holder will fully understand what he or she is investing in. The complexity alone can deprive family members of feelings of freedom. Instead they spend time trying to understand what they cannot and feeling unsure whether they should trust those running the investments. How can a person pursue passions to self-actualization if he or she is busy in a maze of derivatives and jargon?
Many investors now look to an investment approach sometimes called socially responsible (or responsive) investment (SRI). Closely related to this are the concepts of mission-based investing, ESG (environmental, social, and corporate governance), sustainable investing, and ETI (economically targeted investing). These concepts developed over the years in endowments and institutional portfolios as a way to align the wealth holder’s values and worldview with investment strategy.
The concept is that investments can be made in companies that meet certain criteria for improving the world; there are indices, managers, and funds based on that concept. And there are investors, institutional and private, demanding that all of their investments be “socially responsible.”
The challenges for the wealth holder are twofold: getting agreement with other family members on what constitutes SRI, and finding managers who are willing and capable of designing a custom portfolio that reflects the values and cultures of the wealth holder.
A family seeking socially responsible investing for its foundation was given a questionnaire to complete regarding what they considered socially responsible. Some felt nuclear energy was a “good” investment to relieve pressure on oil; others felt it was environmentally irresponsible. Some felt that investments in farming operations were constructive to provide food for the world; others saw those as harmful because they destroyed native habitats. And so the arguments went, and the family conversation finally collapsed in disagreement. The mere selection abstractly of the theme of the investments became a platform for political disagreements and a battleground for the family’s dysfunction.
The family harmony was restored with the presentation of a different process, designed to reflect that each family member had individual needs and values. An investment manager review process was designed in which each family member was separately introduced to three or four investment managers. Each of those managers was an individual investing in his or her own portfolio and owning his or her own company. Each was selected based on some sharing of interests with the family member. For example, one family member was involved philanthropically with programs for disabled children, and she was introduced to a manager with his own disabled child and active community commitment to the cause of disabled children. Each family member selected several managers for family consideration, and then the family interviewed those selected. On the basis of objective criteria and process established prior to those interviews, five or six investment managers were selected. Each of those managers was seen as a friend of one or more members of the family, and all were sensitive to the feelings of the family members.
The value of the foregoing approach to “cultural fit” is that it becomes personalized to leave each family member feeling comfortable with the investments. The approach allows objective evaluation based on subjective input. Incidentally, it teaches the family members that investment professionals are real people, leading real lives, with real loyalties and substantial dedication.
Investment style needs to be looked at strategically first. Who are the wealth holders, what are their comfort levels, what are their values, and what do they want to accomplish with the wealth? These questions must be answered before one even starts to explore how to diversify investment styles.
Any investment program requires due diligence to ensure that policies can be implemented with discipline. Performing due diligence is always daunting. The volatility, chicanery, and uncertainty of 2008 and 2009 have made that task seem almost impossible. Indeed, one might say that today due diligence is the gold standard of investment management. It has become the most important function to execute well to ensure the proper management of significant wealth. Due diligence is broader than simply investigating and monitoring investment managers. Due diligence in its broadest terms is ensuring that all assumptions are correct, that all assets believed to be owned are owned, that all risks are considered, and that all facts are as they are represented. The question to ask yourself is, “Have I considered every risk and do I have the information I need to evaluate every risk?”
The best performance in the world is worthless if you do not own the assets performing; Bernie Madoff’s investment results could not have looked better. Unfortunately, the assets did not exist. The wealth holder must try to understand counterparty risk, that is, whether another party to the agreement (such as a bank) will not live up to its obligations. An investor built a brilliant gold fund in 2007 secure in every respect except that it relied on the solvency of Lehman.
The investor needs to be confident that reporting is accurate as the investor analyzes an investment. Without adequate due diligence, investment decisions are built on sands of information and assumptions that may not be solid. Currencies and reporting of values can be particularly treacherous. Whether tax and other reporting is accurate and verified is central to any compliance program.
The strategic question is how to build a system of due diligence that allows continuing and complete monitoring of all the elements of an investment program. To answer that question of how to structure due diligence, start with the timeless and central question, what is the wealth for? Few wealth holders can say that what their wealth is for is “to allow me to perform the hard work of due diligence.” Even those who enjoy the chase of a good investment, the challenge of building a successful investment strategy, will consider the due diligence process lackluster and uninteresting.
If a wealth holder is willing to rely on one manager and one custodian, due diligence can be fairly simple by examining the security of the custodian and relying on insights of the manager to understand and follow the goals of the client. But if a wealth holder wants to build a more complex investment program, how should that person provide for due diligence? One option is to build a complex, expensive, and less-than-adequate due diligence process by hiring staff to perform the due diligence. There are some huge single-family offices that have many employees performing various elements of due diligence.
Alternatively, the wealth holder can outsource due diligence. Just as many of the world’s largest institutions hire consultants to perform investment due diligence, a wise wealth holder might outsource that role in some way. Any outsourcing should be to companies that are completely unconflicted and who have the bulk of asset base to build the infrastructure necessary. In other words, outsourcing of due diligence should be to an independent and large consultant. Once standards for selection are in place—such as independence, depth of capability, and investment perspective—the provider may itself be the subject of due diligence. However, that due diligence will be primarily to confirm that the clear standards are met and maintained.
Strategic analysis leads to the following conclusion: There are really two elements to investment advisory work, understanding the investment and understanding the investor. Family offices, whether single or multifamily, are ideally suited to understanding the investor. The size of the family office and its relationship with the client allow an intimacy that is conducive to understanding goals and monitoring them. But although a family office may be equipped to consider the investor, it may be less equipped to consider the investment or to perform the heavy-duty due diligence required. For that fundamental due diligence, a company with hundreds of billions of dollars under management can afford to build due diligence infrastructure much more completely than any to be built by even the largest family office. If freedom from wealth and comfort are considered central, for a complex portfolio is it not more strategic to avail oneself of the highest standard of due diligence in investing rather than to look for shrewd, agile, and small investment advisory services? And is it not wise to combine that industrial-strength investment capability with the smaller, more capable family office to understand the investor? Is relying on industrial-strength wisdom to perform investment due diligence not the way to create the comfort needed?
Finding the expert in investment—due diligence—is not easy for the private wealth holder. Unconflicted consultants with the infrastructure large enough to build a complex process of due diligence are difficult to locate. In fact, there are probably no more than five or six in the United States and far fewer elsewhere. If investment policy demands opaque and complex programs, due diligence requires the ideal investment consultant. When that ideal consultant cannot be accessed, then pragmatic considerations become the strategic reason to simplify the investment program. Selecting the right investment program starts with consideration of what level of due diligence can be found. If there is an “industrial-strength” consultant available, the program can be intricate and complex if that is desired. If a consultant is not available, simplicity, even mutual funds or long stocks and bonds, may be ideal. That’s not because those “vanilla investments” will provide the best abstract performance but rather because they do not require an unattainable understanding of complex diligence issues.
One family office I was acquainted with designed the ideal investment program for the family. It was to be built around alternatives and derivatives, but with a portfolio much smaller than would be of interest to an institutional, independent consultant. The family found that it could hire consultants who built funds of funds, others who were owned by manufacturing companies, and others who had ties to specific products. That family decided, quite reasonably, to modify its investment program by hiring four or five managers who bought only stocks and bonds; and they found a fine, small, independent consultant willing to work for them to find and monitor those managers and confirm that custody. They designed their portfolio around what was possible rather than around what was ideal. That was strategic to help them achieve their purposes.
A father recently decided to search for new investment managers for the family portfolios after many years of reliance on a large bank. He concluded that as his 21-year-old son became interested in investing, he could engage his managers to help develop his son’s understanding. He set out certain requirements strategically designed to accomplish his purposes of educating his son. He wanted each manager to be a small company, an individual or individuals governing their own fates, building their own businesses, and fully invested in their businesses. He wanted each to be a “full” person with passions and interests beyond the investment business. He wanted each manager to be willing to talk about himself or herself, the process used in selecting investments, and the hard work of being in the investment business. Managers were selected and interviewed. In each, the son saw hardworking, disciplined, and process-oriented real people who rose and fell with their own investment decisions. Each was his or her own master and each lived the consequences of his or her decisions.
The selection process itself taught valuable lessons to the son. First and foremost, the son learned that investment management is a profession. Picking stocks and managing a portfolio was not an avocation that a person could dabble in. Managing money is a difficult and time-consuming business, and that is an important lesson. Next, the son saw that entrepreneurship is hard work with its ups and downs. Real people have real lives, and business and life take place together. Sometimes, coordinating life and complex work can be difficult. Finally, the son learned a bit about investment theory from people who were passionate, principled, and wise.
Another story also helps illustrate this point. A family whose wealth came from entrepreneurialism and continues to be built on entrepreneurialism is considering a private equity fund to be run by members in their 20s and 30s. The family will place a substantial amount of money in the fund, will hire a professional private equity expert, and will allow the younger family members to guide the fund as directors. The primary strategic purpose of the fund is not to produce investment return; it is instead to teach the younger members of the family about business. The first lesson to be learned is that starting a business and running it requires discipline and very hard work; the second lesson is that nine out of ten businesses will fail; the third and overarching lesson is that one does not “dabble” in investing, in entrepreneurship, or in business.
Are the foregoing strategies investment strategies or next generation education strategies? The answer is that they are both. A good strategy helps accomplish all purposes. In the first example, the portfolio of managers resulting from the process was sound; so were the lessons learned about life and wealth. In the second, the private equity investments would probably do fine, but the understanding of private equity, of building a business, would be extraordinary.
In fact, often forgotten in any investment strategy is that it is about more than just investment. Many years ago, I learned that the best investment advisors and stock brokers told stories. The story of Xerox, IBM, or Minnesota Mining brought investment to life and taught that investment was about creating jobs and value and world betterment. Read any year’s annual report for Berkshire Hathaway and you walk away feeling that substance is taking place, business is being done, and hard work is creating jobs and value. Consider a manager looking for values in the renewable resource area, whether wind or sun or water, and how those stories can resonate with people looking forward to a long, productive life. A sound investment program reflects what we have learned about ourselves and our world. A good education program teaches us about ourselves and our world. The two go hand in hand.
A wise observer of family businesses distinguishes between the “investor” and the “owner.”* Multigenerational wealth is about ownership, not merely investment. But how do we teach ownership using derivatives, passive investments, and pure quantitative analytics? How do we teach the role of our wealth in a community and the involvement of wealth holders with professional managers?
If we are looking at multigenerational wealth, we must recognize the role of investment in education. Expressed differently, we must try to connect our children and grandchildren to their wealth by allowing its investment to come across as real and productive rather than hocus-pocus magic. I will not enter the debate on whether passive investing provides more return at less cost or whether sound derivative and alternative investing can be just as secure as stocks, bonds, and real estate. But I can suggest that interesting stories and productivity provide a grounding that allows younger people (and older) to feel more comfortable and interested in their investments.