Could Your Family Benefit from An Independent, Outsourced Chief Investment Officer? Part II

By Richard Todd, Wendy Dominguez, MBA, Scott Middleton, CFA, CIMA®, and Kristy LeGrande, CFA, MBA

The first step in creating an appropriate investment structure is to confirm your investment objectives, risk tolerances, time horizons, spending and the role of the portfolio in your overall family enterprise. Agreement on all these items should be achieved prior to deciding on investment mandates for investment advisors.

A few considerations:

1. What are the potential uses of the funds? Near term, longer term?  What would cause this to change? Should all investments be managed in same manner?

2. If you have a large private or public holding in a specific industry (such as real estate or energy), you may wish to exclude additional investments in these industries from the rest of the portfolio. If you engage in a high-risk business (for example, a start-up), perhaps the remainder of investment portfolio should be invested in a more risk-averse manner.

3. What is the scale of the assets?  Would you benefit from keeping investments with one advisor to benefit from economies of scale regarding fees and trading costs?

4. What role will the investments play within the overall family enterprise? How much volatility can be tolerated? 

Governance – Policies and Process

The culmination of the knowledge referred to in the above section should be documented in a formal Investment Policy Statement (IPS). The IPS should be reviewed on an annual basis, at a minimum, or whenever your family situation changes. The policy may address the cash flow needs from the portfolio, as well as important governance issues that address the following questions:

1. Who is authorized to make investment decisions? Family, committee, independent OCIO?

2. How frequently do formal family or committee meetings take place?

3. Are family members the only decision makers, or are outside trustees involved?

Portfolio Design and Asset Allocation Characteristics

Portfolios that are run by different advisors can have dramatically different risk and return characteristics. It can be helpful to quantify the characteristics of each portfolio to help understand the differences and determine whether each portfolio is constructed to meet the family’s objectives. Forward-based capital markets assumptions must be utilized, as historical asset class rates of return can be highly misleading in quantifying characteristics. For instance, historical long-term fixed income returns are much higher than forward-looking expectations because current rates are low relative to history. When equity valuations are high as well, one could argue that future stock returns would be muted. Figure 1 illustrates the characteristics of a portfolio (IPS) as well as several potential asset class mixes that could improve the overall risk/return profile of the portfolio.

While return objectives are one important component of portfolio construction, downside risk should also be considered. In Figure 1, the 95th percentile depicts a one-in-20 chance of a loss in a one-year period. In other words, to expect an average annual return of 6.00 percent in Mix 1, you would need to expect that the portfolio could drop by 14.00 percent in a bad market.  Understanding risk is vital and will help a family stay grounded in down markets. Emotions run high when markets fall steeply, leading to investment mistakes. By quantifying downside risk, portfolio construction can be based on what the family can withstand in unpredictable times, and therefore decisions made in downturns become less emotional.

The next edition will be focused on evaluation of products, managers, and strategies. Let us know if you would like a copy of the Innovest full white paper.