Many family offices prefer to hire and monitor their money managers internally rather than through a third party. Sometimes it’s to lower costs or because the family office has specific ideas on the type of advisor they want to work with. Moreover, they may want to develop a long-term relationship with a manager and need the familiarity that comes with conducting due diligence on someone.
Family offices that go this route, however, need to understand the hurdles they will face and whether their operation is sufficiently staffed and skilled to address them.
To gain a better understanding of the work involved, let’s review some of the most common mistakes family offices make in this type of endeavor:
Who’s In Charge?
A common mistake is failing to understand who is really in charge at an advisory firm. Sometimes you have to follow a firm for several years, gaining a full understanding of its evolution and history, to know the answer.
We know of one consultant who, while doing due diligence on a money manager, was introduced to someone by the firm’s marketing department as its “key decision-maker.” When the consultant revisited the firm a year later, this important person was no longer with the firm. The same marketing person said, “He was not really that important and never really managed the money.”
The moral of that story is that it takes considerable time to conduct initial due diligence, and even more to do proper ongoing due diligence. Family offices that undertake their own due diligence have to make sure they have the staff and the time to devote to such thorough investigations.
Dissecting Performance
Family offices need to fully educate themselves on the intricacies of performance reports, which can sometimes be deceiving because they can be structured in a variety of ways.
One of the first things to ask is whether the performance is Global Investment Performance Standards (GIPS) compliant. The GIPS program lays out straightforward guidelines and methods by which performance should be calculated and displayed, and provides a common framework for comparing portfolios with similar mandates.
Beware the use of composites (which are also covered by GIPS) and ensure they are representative and do not suffer from “survivorship bias,” where lost accounts are deleted (for poor performance perhaps?). Also, make sure they are compared with appropriate benchmarks.
Many family offices learn the hard way that performance reports are not always representative of the strategy, product or portfolio manager under consideration.
Looking Under The Hood
Money management firms can undergo changes that are so subtle they go undetected by even the most diligent monitoring programs.
One manager in the late 1990s had a stable firm, a deep and experienced research and portfolio management team and a 10-year track record of beating its benchmark. Things had gone so well, however, that the portfolio manager started to take bigger bets, doubling up exposures to smaller and more volatile names. The ongoing monitoring of the manager, both through one-on-one meetings and analysis of portfolio holdings, showed the manager taking on risk beyond what it said it would in its investment process.
The result was that portfolios became more concentrated and more volatile, and soon performance began to suffer. If a family office does not allocate the resources to perform a “deep dive” on a manager’s portfolio and performance, they risk being too slow to recognize and exit a situation that may be going downhill. In this case, the manager underperformed for the next four years, had major staff defections and saw half its clients leave.
The Ideal Candidate
Family offices need to develop their own philosophy about what they are seeking in a money manager—what is known as the “big vs. boutique” discussion.
Family offices come in many sizes, both in terms of assets under management and staff, objectives and sophistication. Some want the close attention that may only be available from a small boutique investment firm that perhaps caters to the ultra-high-net-worth market. A large asset aggregator can provide the same investment deliverable, but the service set may not fit with the needs of the family office.
Or it may be that the family office needs or wants a customizable solution—such as an advisor that specializes in socially responsible investing—that some firms are not able to provide and may only be available through a boutique firm.
For some family offices, however, smaller boutiques may involve risks they wish to avoid. For example, many small firms depend on one or two key people whose departure could jeopardize the investment process or the business itself. Or it may be that the firm is simply not large enough to perform the securities research and portfolio risk management larger firms can offer.
Long vs. Short Horizons
Family offices should avoid getting swept up in short-term thinking and be aware of the impact that behavioral psychology will play when reviewing a manager’s performance. Inevitably, a manager will underperform and there will be pressure within the family to terminate the manager and cut losses.
Investors need to have a very clear understanding of what a firm’s process should be expected to deliver in terms of performance and volatility, over a short as well as long-term time horizon. Review performance in the due diligence stage of not just annualized performance, but also quarterly performance relative to the benchmark, over at least a five-year horizon. This should give a good indication of the extent of the expected drawdowns. If the numbers make you nervous, the manager may not be right for you.
To get a better perspective on the ups and downs of asset management, consider these findings from a study conducted by Baird and Associates concluding that a short time horizon for evaluating performance may not be optimal:
• Over a 10-year period (ended December 2010), for a group of mutual funds that beat their benchmark by at least 3% annualized, 81% underperformed their peers over some three-year period. Twenty-five percent of these managers underperformed their benchmarks through at least one 12-month period over that time.
• When mutual funds were upgraded in Morningstar, fund flows increased, while fund flows decreased for those downgraded a notch. Yet the downgraded funds outperformed the upgraded funds anywhere from 30 bps to 70 bps.
• The longer you hold, the greater the odds of success. Fifty-nine percent of managers outperformed over rolling one-year periods; 68% over rolling three-year periods; 73% over rolling five-year periods; and 82% over rolling seven-year periods.
New Not Always Better
Dealing with a new firm with little in the way of a track record is risky. A family office may make the mistake of thinking they have found a “diamond in the rough” and may want to get in on the ground floor of a new and exciting business enterprise that will add value to their portfolio.
Most small asset managers are started by a few professionals who grew up as a team at another firm or who worked together in the past. A family office that has an in-house research staff may already know the individuals from their prior firms, or be familiar enough with the prior firm’s investment process to make the due diligence process easier. If not, a family office has little to go on in evaluating the firm and has substantial business risk in being one of the first in the door.
This can be mitigated by networking with other family offices that may know the principals from their prior firm, as well as asking for references and doing detailed background reviews of the principals. Reviewing prior performance, or what expectations should be for the new firm, makes it easier to accomplish a thorough review and determine the level of interest in the manager and their product.
