Family offices Aligning investment risk and return objectives
Family offices Aligning investment risk and return objectives Background Between July and August of 2012, the Financial Times conducted biannual Family Office Survey with the results published in a report towards the end of 2012. Family offices located around the world (but predominantly based in the UK or the US) were invited to express their opinions on many topics such as risk tolerance, asset allocation and performance expectations. Over 120 family offices, with an average asset size of 776 million, took part in the survey. The survey revealed some interesting results. For example, despite seemingly low risk appetites, the average family office still has an allocation to high risk assets of over 70%. Also, even in an economic climate with low yields and increased uncertainty, the majority of family offices are targeting returns of 4% or more above current cash rates. This paper explores some of these interesting survey results in more detail. Capital preservation is increasingly important As would be expected, family offices levels of risk aversion have increased since the 2008 global financial crisis. Before 2008, 23% of family offices described themselves as risk averse. According to the survey, this number has now doubled to 46%. Consistent with this, the survey also found that capital preservation and risk reduction consistently ranked highest when family offices were asked to define their primary strategic goals. Investment risk appetite appears to have fallen over the last five years, and similarly strategic goals have also shifted from return-seeking to more of a focus on risk management. However, the results of the survey highlighted what appear to be some inconsistencies between current levels of risk aversion, the asset allocations being adopted and the levels of return being targeted. Investment risk appetite appears to have fallen over the last five years, and similarly strategic goals have also shifted from return-seeking to more of a focus on risk management. 2 towerswatson.com
Family offices continue to adopt high-risk investment strategies Figure 01 shows a representation of the average family office asset allocation taken from the survey. Overall we note that the average family office portfolio has an allocation to higher risk assets of 72% and only a 28% allocation to lower risk fixed income assets and cash. It appears that, on average, family offices are still running relatively aggressive investment strategies despite their contracted risk appetites. To help quantify the levels of risk and return being run under these asset strategies, we have used the Towers Watson Investment Model to calculate the risk and return for the average family office portfolio and each of the individual participant portfolios (see Figure 02 below). Figure 01. The average family office asset allocation 28% 28% Lower risk assets 72% Higher risk assets Higher risk assets Lower risk assets 25% Equities 21% Absolute return/hedge funds 17% Real estate 14% Private equity 7% Emerging market and high yield debt 6% Emerging market equity 4% Commodities 1% Tangible assets 6% Other 64% Fixed income 36% Cash Figure 02. Participants displayed a broad spectrum of risk/return levels Long-term expected return (pa) 8% 7% 6% 5% 4% 3% 2% 1% 0% 2% 7% 12% 17% 22% 27% 32% One-year volatility Individual family office allocations Average family office allocation Family offices Aligning investment risk and return objectives 3
According to our assumptions 1, the average family offi ce allocation has a one-year volatility of return of around 11% and a 10-year expected return of around 5.5% pa 2. This means that roughly two-thirds of the time we expect the portfolio to achieve a return of between 5.5% and +16.5% over a one-year period and one-sixth of the time for a return lower than 5.5%. Hence there is reasonable chance that for the average family offi ce, the key objective of capital preservation will not be met. In addition, the comparison for many of the family offi ces suggests even riskier asset strategies are being adopted. In our view, the analysis above suggests a misalignment between portfolio risk levels and the key family offi ce objectives of capital preservation and risk reduction that should be reconciled. Are the investment returns being targeted achievable? As part of the survey, family offi ces were asked to state their medium-term investment return targets. To put these stated return targets into context, we have compared the expected returns based on the individual family offi ce asset strategies against these targets. In Figure 03 we show two pie charts. The chart on the left shows the answers to the return target survey question split into four different ranges. The chart on the right shows which of these ranges the individual participants fi t into according to our asset model return assumptions and their stated asset allocations. Figure 03. Overly optimistic return targets? Survey results Towers Watson expected results Gain of 0% 3% Gain of 3% Gain 6% of 0% -3% Gain of 3% - 6% Gain of 6% 10% Gain of 10% Gain or more of 6% -10% Gain of 10% or more 1 All assumptions in this paper are as at 30 September 2012. 2 This is the 10-year annualised median return from our model. 4 towerswatson.com
Looking at the survey results, we note that around 15% of family offi ces are conservative, targeting returns between 0% and 3%. Over a quarter of respondents are aiming for what we would consider to be realistic returns of between 3% and 6%. Interestingly, the overwhelming majority are targeting returns of between 6% and 10% and nearly 10% are targeting returns of 11% or more. Looking at our expected returns, we see that we expect roughly three-quarters of the family offi ces that took part to fall in the 3% -6% return range and a quarter to fall in the 6% -10% return range. We also note that the maximum expected return from our model was just 7.5% pa. From this we can deduce that many family offi ces are targeting unrealistic levels of return and/or are using overly optimistic long-term asset return assumptions. Either way, it seems that a large proportion of family offi ce return targets again appear inconsistent with capital preservation objectives and current heightened levels of risk aversion. What about the current environment? One explanation for the possible misalignment of return targets with expected returns is the current economic environment, with very low levels of cash and bond yields meaning expected returns for many of the lower risk asset classes are at close to zero. Hence, it is possible that the return targets have not yet been updated to refl ect the new normal of the post global fi nancial crisis economic climate. Consistent with the low level of cash and bond yields, the investment community is presently debating whether markets are beginning a great rotation : a large-scale movement of capital out of higher-grade bonds and cash into equities and other risky assets which would cause a sharp outperformance of equities over bonds. At present, our view is that equities will outperform bonds over the medium term, which is mainly driven by our view that the conditions discounted in both equity and bond markets are too pessimistic (that is, we believe that bonds are expensive relative to equities). The survey showed that there has been an increase in appetite for equity and private equity relative to the last time the survey was completed in February 2012. For example, in February 2012 36% of respondents said that they were planning to increase their allocation to equities in the following 12 months. The August 2012 survey revealed that this fi gure had jumped to 49% of respondents. Conversely, appetites for fi xed income assets have reduced materially. In February 2012, 25% of respondents said that they were planning to decrease their allocation to fi xed income assets in the following 12 months. The August 2012 survey revealed that this fi gure had jumped to 40% of respondents. So it seems as though family offi ces are also buying into the rotation hypothesis, which appears to contradict the heightened levels of risk aversion and risk management focus discussed earlier. In reality family offi ces hands are being forced. At present, like all investors, they are having to perform a balancing act between managing risk and hunting for adequate yields in a climate where global monetary policy has driven interest rates and bond yields down to all-time lows. Family offi ces Aligning investment risk and return objectives 5
Can greater diversity better align risk and return expectations and aspirations? One approach to moving expected risk and return towards that required is to more effectively diversify the return exposures in the portfolio thus improving investment effi ciency (that is, to increase return per unit of risk). We note from Figure 01 that the average family offi ce portfolio appears to be quite well diversifi ed away from a traditional equity/fi xed income portfolio. We also note that family offi ces are looking to increase their level of geographic diversifi cation as the survey showed a material increase in appetite for emerging market investments (both debt and equity) since the February 2012 survey. But does the average family offi ce allocation diversify enough? We believe that further asset class diversifi cation is warranted. Figure 04 compares the main drivers 3 of returns for the average family offi ce portfolio with a scaled version of Towers Watson Investment Committee s model portfolio (scaled to have the same expected return as the average family offi ce portfolio). Return drivers represent the different sources of investment risk that are rewarded with investment return. The model portfolio spread between return drivers (see the grey bars in Figure 04) represents our view of an ideal long-term strategic spread across these drivers. Figure 04 shows that, relative to our model portfolio, the average family offi ce is overweight the equity risk premium. It also suggests that sources of outperformance can be further improved by investing in assets that are linked to the credit, insurance and currency risk premia since the average family offi ce portfolio is underweight in these areas. Figure 04. Family offices remain reliant on the equity risk premium 60% 50% 40% 30% 20% 10% 0% -10% 49 41 11 13 15 14 2 6 16 6 Average family office allocation 4 Scaled model portfolio 24 24 Equity Credit Illiquidity Insurance Currency Skill Term/inflation Figure 05. Portfolio risk/return characteristics Average family office allocation 4 10-year expected return (pa) 6.1% 6.1% One-year volatility 10.6% 9.2% We see that the scaled model portfolio has the same expected return as the average family office allocation but with a reduction in risk of around 15%. -3 Scale model portfolio -4 Figure 05 shows the risk and return statistics for the two portfolios. We see that the scaled model portfolio has the same expected return as the average family offi ce allocation but with a reduction in risk of around 15%. 3 See the appendix for further information. 4 Best-in-class alpha assumptions have been assumed to ensure a like-for-like comparison with the scaled model portfolio. 6 towerswatson.com
How can further diversification be achieved? There are further asset class diversification ideas (some of which are utilised in the model portfolio described above) that have not traditionally been used within family office portfolios, but would be expected to increase overall investment efficiency. Hence we believe that the implementation of these ideas would better align family office portfolios with their current risk/return objectives. One of these ideas is around the wider use of alternative beta strategies. These strategies sit somewhere between the common market return drivers ( beta ) and idiosyncratic returns from active management ( alpha ), and offer effective diversification with a relatively low governance requirement. As alternative betas are now becoming more mainstream and accessible, investors are now able to obtain direct access to these asset classes at a lower cost. Conclusions The survey revealed that family office risk appetites have fallen materially over recent years, and that strategic goals have also shifted from return-seeking to more of a focus on risk management. However, the survey also indicates that, for the most part, family offices continue to adopt higher-risk investment strategies and some have return targets that have a low likelihood of being achieved in the current economic climate. In other words, we see an apparent misalignment between investment risk levels and return targets, and family offices principal objectives of capital preservation and risk reduction. This misalignment is being exacerbated by current market conditions where all-time low interest rates are forcing investors into higher risk assets like equities, high yield bonds and emerging market debt. From the perspective of robust risk management, we recommend that family offices review and resolve this misalignment between risk and return objectives, although this is likely to require some compromises. In addition, asset classes do exist that can further increase diversification and hence help further bridge the gap between what is desirable and what is practically achievable in return terms under the current environment. Further information For further information, please use our contact details below: Michel Meert Senior Investment Consultant +44 1737 274143 michel.meert@towerswatson.com Eric Zwickel Senior Investment Consultant +44 20 7227 2052 eric.zwickel@towerswatson.com Andrew Epsom Senior Investment Strategy Consultant +44 1737 274044 andrew.epsom@towerswatson.com Appendix Return drivers Towers Watson believes that there are a number of fundamental drivers of return. We believe that exploiting a mixture of these drivers, through investing in various asset classes, can improve the expected financial efficiency of an investment portfolio. We note that single asset classes can be exposed to multiple return drivers: Return driver/risk premium Equity Credit Illiquidity Insurance Term Inflation Currency Skill Investors are rewarded for bearing the risk of: Being lower down the capital structure in the event of corporate default Corporate bond issuers defaulting on their bond obligations Holding an asset that cannot be quickly or cheaply sold Providing protection against extreme losses The uncertain return and mark-to-market volatility of an index-linked bond compared to holding cash Inflation being higher than anticipated and therefore reducing real returns on fixed-interest bonds The risk that the purchasing power of the currency falls due to a currency crisis A manager, previously considered skilful, underperforming its benchmark Family offices Aligning investment risk and return objectives 7
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