Alignment of Interest is Key to a Successful Long-Term Client-Manager Relationship
Investing means different things to people. The differences include objectives, time horizons, approach to risk management, and fundamentally to the alignment of interests between clients and managers.
Unfortunately, in the scramble for investment income and returns, some of the core attributes of investment and portfolio management are overlooked. This is problematic for families looking to grow and preserve their wealth over the long-term, particularly in the context of myriad complexities and uncertainties.
Alignment of interest
Many clients are easily attracted by positive historic returns to the extent they fail to carry out proper due diligence on an investment, or the investment manager. A key element is to understand investment manager compensation and the degree to which this may be in conflict with the investor’s interests. In many cases—as is typically the case with a lot of private banks—an investment manager or advisor is paid commission on transactions. In such a case, an investor may falsely believe that there is an alignment of interest since fees are only paid when something is done.
But this isn’t true.
Patience is required to generate very substantial returns. This means making an investment and then giving it the time to increase in value. But an investment manager/advisor has revenue targets that could sometimes even be assessed by the investment company bosses on a weekly basis. This puts enormous pressure to “churn” trade activity. The advisor is motivated to over-trade and to constantly encourage clients to take small profits and roll into the latest “trade-of-the-week” idea. This is not aligned with clients’ interests.
It can become even more disingenuous when investment advisors sell structured products. Such products are often represented as a less risky way to provide investment exposure to clients. The reality is there is an expensive price to pay on the part of the client and one that does not properly reward clients for the risk they are taking. For the most part, clients would be better advised to utilise listed options and direct asset exposure, but these better client solutions do not generate much revenue for the typical investment advisor. There are embedded (often hidden) deductions from clients’ capital every time they are sold a structured product; and clients are often encouraged to renew structured products multiple times per year with significant negative impact on capital.
The misalignment of interests between manager/advisor and client can jeopardise the long-term objectives of the client, as recent developments involving the wealth management business of a very large Swiss bank and its relationship with a financial services firm—now insolvent—have shown. This bank was both a lender to the firm and a distributor of its products, directly compensated for distributing specific funds and making revenues from providing leverage to them. Some of the world’s leading banks have also been caught napping through the implosion of US single-family office Archegos, which may more aptly be called a family hedge fund.
Compensation structures determine whether there is an alignment of interest. External asset managers and private banks are largely focused on growing their assets under management and for many, revenues are created through transactions and lending.
Family offices are different, tending to look at longer time horizons, with shorter tactical overlay or fewer tactical allocation changes. The family office is not rewarded for the number of transactions it makes and can instead have the patience for assets to grow significantly. It is vastly different from trading—often passed off as investment—wherein the trader is focused on the short-term and the desire to make small gains, resulting in missing the big and long-term moves entirely.
The full picture
A true family office cares about the longer-term preservation and growth of a client portfolio as well as the family capital, and less on short-term small gains.
The role of a multi-family office is to understand a family’s investment objectives, alongside the constraints it operates in, with a view to create the best possible portfolio. Multi-family offices have the advantage of a comprehensive overview of the client’s wealth and business interests.
Often, banks don’t have visibility beyond their direct relationships with a client while clients often have more than one banking relationship. In fact, this is frequently the root cause of an overlap of investment strategies by different advisors, which can lead to suboptimal results.
For family offices, generating returns is only one aspect of investment management; they also consider the legacy or values that a family wants to become known for? And how can their approach to investing align with that?
Family members may have different expectations for the family wealth: while some may want the preservation of money for the family business, or in income flows, others might want more aggressive growth-oriented portfolios. Family offices are able to reconcile these different goals, thanks to the complete visibility over all of a family’s business and investment affairs.
This ties in strongly with risk management.
Understand and manage risk better
Family offices are inherently better placed to manage risks and diversification as they often have broad and deep visibility over all commercial activity of their clients – including banking relationships, investments and businesses. This provides family offices with the ability to take an objective overview and allows them to manage risk—and diversification—more successfully.
A single investment advisor may be keen to recommend diversification at the portfolio level that they manage. Where a client has different investment advisors, the portfolios may look quite similar. This can create undesirable and often unnoticed investment risks. However, a family office, seeing all the investment portfolios, is able to consolidate exposures across multiple custodians so that there is clarity on overlapping or correlated investment exposure.
A related point is that most investment managers see cash in a client portfolio as an opportunity loss. They would rather minimise the cash holding and use it to create revenue through additional transactions. Family offices, on the other hand, may be quite comfortable with higher cash holdings if the market risk seems too high or if they are waiting for better entry points to deploy capital.
Another consideration often overlooked by investment managers is the relationship between the investment portfolios and the family’s principal business. In the desire to find attractive returns, the investment manager may end up with holdings that have a high correlation to the family business. This can lead to unwelcome concentration risk which becomes more visible when there are economic shocks to a particular business or geography. The last thing a family needs is to face a problem that negatively affects the underlying business and then to realise that their investment portfolios are suffering in the same way.
As a further risk management opportunity, well-established family offices also provide clients with a greater degree of access to private direct investments. Such investments may be purely focused on returns but can also be more strategic in relation to the underlying family business. Whereas making direct investments through banks can be a somewhat bureaucratic process, experienced family offices professionals are often able to quickly assess deals and the fast decision-making tends to attract other deal flow.
A fine balance
At Golden Equator Wealth, we help clients preserve, build and enjoy their wealth for generations. We are commonly asked whether wealth preservation or enhancement is more important. We believe it is about finding the right balance for each family.
Even wealth preservation requires a degree of growth to cover for inflation and to maintain purchasing power over time. Growth is also required to cover for big drawdowns that can happen when least expected.
We saw it happen in February and March last year owing to Covid-19 when most asset classes were hit very hard.
Hospitality businesses are a popular investment for wealthy families, with many running and owning stakes in hotels around the world. Investors in these businesses suddenly found their assets were not generating any returns and had become a cost rather than an income generator. We saw the same happen with retail and with large landlords. What was once a relatively predictable income stream was no longer so. Having cash available helped to soften the blow in this difficult period and allowed clients to take advantage of new opportunities.
Developments related to the pandemic have resulted in acknowledgement that a degree of diversification is important both from wealth preservation and enhancement perspectives, and that the two are not mutually exclusive.
A change in approach
A focus on multi-generational wealth and legacy preservation is the hallmark of investing through a family office. This is made possible through clear alignment of interests with clients, deeper and more comprehensive risk management and a focus on long-term growth and value.
In the years of being served by investment advisors, families have been conditioned to fall into certain bad habits such as chasing short term returns, over-reliance on structured products, and poor risk management, that we see impacting their portfolios today.
Changes in mindset and approach are required in how clients and families invest and manage their wealth, if their long-term focus is in ensuring that their legacy lasts beyond the third generation.
Many have heard of the old proverb “Shirtsleeves to shirtsleeves in three generations.” In Japan, the expression goes, “Rice paddies to rice paddies in three generations.” In China, “Wealth does not last beyond three generations.” These depict the challenges wealthy families face in sustaining and passing on their wealth.
The Hubbis Independent Wealth Management event of May 11 in Singapore featured a panel discussion that focused attention on how EAMs can strive to differentiate themselves through the curation of new and interesting investment and product ideas, and through more comprehensive engagement with clients and their family members. Gary Tiernan, CEO of Capital at Golden Equator Wealth, sat as one of our expert panellists. Hubbis summarises some of his views in this short report.