How does a multi-family office invest?
The investment strategy of a multi-family office (MFO) is typically based on a broader range of asset classes than high-net-worth clients may be accustomed to from private banks or financial advisers. Portfolios tend to be more diversified, include significantly more alternative investments, and place greater emphasis on a long-term investment horizon and outperforming inflation. There are also generally fewer conflicts of interest than is often the case with banks and similar institutions.
MFOs generally do not attempt to make numerous small discretionary decisions when constructing a portfolio. Nor do they try to predict precisely where we are in a historical or economic cycle and how individual assets will behave as a result. Instead, they rely on long-term data spanning many decades and apply it to an investment strategy that, by its nature and at its core, should not be fundamentally altered.
Put simply, returns over a longer period, say 15 years or more, are determined more by the assets held within a diversified global portfolio than by individual decisions about entry and exit points.
An MFO portfolio is therefore usually structured to reflect the partner family’s risk profile and fulfill its required functions, particularly in terms of the relationship between return and risk, volatility, cash flow, and liquidity.
Although every MFO partner is unique, they share several common characteristics: they invest for the long term, diversify, use alternative assets, and seek to outperform inflation.
Multi-family office investment strategies are also still strongly influenced by geography, particularly because of the different historical developments and experiences across regions such as North America and Europe compared with Asia, Latin America, or Africa. Even here, however, we are seeing a gradual globalization of approaches and investment solutions, regardless of the age of the family office or the investment experience of the investor’s home country.
The fundamental building blocks of a multi-family office are long-term investing, beating inflation, diversification, and investment opportunities for qualified investors
We distinguish between two basic types of family offices most commonly encountered in practice.
A family office serving primarily one family is a single-family office (SFO). One common difference compared with a multi-family office (MFO) is that an SFO’s investment strategy is often influenced by the family’s previous or current business activities.
Founders tend to steer the strategy toward areas where they can draw on their previous experience or toward industries in which they personally wish to remain active. Some families also find themselves in a complex situation because their existing business represents such a dominant share of their overall wealth that achieving even basic diversification becomes very difficult.
Multi-family offices, by contrast, can approach the relationships between families, individuals, businesses, and the resulting portfolios in a much more agnostic way. The focus is on three core principles:
- long-term investing and outperforming inflation,
- global, currency, and thematic diversification,
- investment opportunities for qualified investors.
A long, or even effectively infinite, investment horizon allows MFO partner families to invest in less liquid and more ambitious assets that may generate attractive returns over the long term. By giving an investment decision sufficient time to unfold, investors can generally avoid poor or rushed decisions. Such decisions can otherwise have a significant negative impact on the performance of an individual investment and, ultimately, the portfolio as a whole.
Diversification in this context is no longer simply about combining stocks and bonds in a ratio determined by the investor’s risk profile. It also involves managing market, credit, and, importantly, geographic risks. This becomes particularly relevant when we consider alternative investments, which can cover a very broad range of market segments.
Although technological progress and the democratization of investing have made access easier in some respects in recent years, attractive opportunities are still often available only to sufficiently large or qualified investors.
In this context, “qualified” does not necessarily mean having deep knowledge of the investment itself. Rather, it refers to the ability to make a meaningful investment, for example more than EUR 125,000, without that investment representing a fundamental risk within the investor’s overall portfolio.
This brings us to another advantage of an MFO: the ability to pool capital and participate jointly in larger and often more interesting direct investments through so-called club deals.
MFOs draw inspiration from Modern Portfolio Theory and endowment-style investing with an infinite investment horizon
MFO investment strategies are often based, among other things, on two fundamental concepts.
The first is the academic concept of selecting investments to maximize returns for a given level of risk, known as Modern Portfolio Theory (MPT).
The second is the investment approach used by institutions that, by the nature of their objectives, have an effectively infinite investment horizon or an obligation to distribute part of their returns to meet ongoing liabilities, commonly associated with endowments.
We will look at these two concepts in more detail below, as understanding them is essential to understanding the broader philosophy of how multi-family offices invest.
Modern Portfolio Theory is a practical method for selecting investments to maximize total return within an acceptable level of risk
he theory originated with American economist Harry Markowitz and his 1952 paper, Portfolio Selection. In 1990, Markowitz, together with Merton Miller and William Sharpe, received the Nobel Prize in Economic Sciences for their pioneering work in financial economics.
What does the theory tell us?
An investor can construct a portfolio of multiple assets that provides higher expected returns without necessarily taking on a higher level of risk.
Alternatively, given a required level of expected return, an investor can construct a portfolio with the lowest possible level of risk capable of delivering that return.
Using statistical measures such as standard deviation, variance, and correlation, the performance of an individual investment becomes less important than the effect that investment has on the portfolio as a whole.
By combining assets with different risk and return characteristics, the overall behavior of the portfolio can be significantly altered.
Modern Portfolio Theory naturally has its critics. In particular, the methodology evaluates portfolios using variance, while investors may care much more about downside risk. In other words, it is not necessarily a problem if some asset classes within a portfolio experience more significant fluctuations. What matters is that the long-term aggregate result is positive rather than negative.
Endowments have gradually expanded their portfolios into alternative assets
The origins of endowment funds created at the world's largest universities The origins of endowments established at some of the world’s leading universities date back to the early 18th century.1
The objective was, and remains, to invest donations so that they continue to generate income for the institution rather than simply being consumed.
If only a similar perspective could make its way into the Czech endowment ecosystem. Although we are beginning to see the first signs of it here as well.2
The shift from bonds, which provide a fixed return, toward equities dates back to the 1930s and 1940s. Even the Nobel Foundation, for example, was originally invested primarily in bonds. Had its statutes not eventually been changed to allow investment in equities, it might not have survived in its present form.
In the 1980s, university endowments increasingly began moving away from traditional assets such as listed equities and toward alternative investments, including hedge funds, private equity, venture capital, and real assets such as oil, timber, and other natural resources.
As the example above illustrates, endowment-style investing is often distorted and sometimes incorrectly applied by the investment community. Probably not intentionally, but rather through the simplification of facts and information that are then repeated without a deeper understanding of the underlying principles.
Endowments benefit from alternative investments and privileged networks of contacts
A typical endowment:
- Allocates capital across broad asset classes designed to provide diversification through relatively uncorrelated sources of return. This means genuinely diversifying strategies and asset classes, rather than conventional allocations dominated almost entirely by equity and bond risk.
- Reallocates part of its capital from traditional asset classes, such as equities, bonds, and cash, toward alternative assets and investment strategies, including private equity, real estate, hedge funds, and other, typically less liquid, strategies. The Yale University endowment, frequently cited as a model for endowment-style investing, is a good example. Its former CIO, David Swensen, is widely credited with developing and popularizing this approach. Only around one-quarter of the portfolio has historically been allocated to traditional assets, with approximately three-quarters allocated to alternative investment strategies.
- Builds its investment portfolio through managers who are difficult for retail investors to access. It is important to understand that networks and alumni relationships can give these endowments access to exceptional investment managers, often early in their careers or during the first fundraising rounds of new funds. Endowments can negotiate terms, including lower management fees due to the scale of their commitments, and monitor risk management in considerable detail. This final principle is perhaps the most difficult to replicate and one of the main reasons why successfully copying the model of leading university endowments is so challenging.
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In an MFO context, this means investing for the long term, diversifying broadly, and including alternative assets based on endowment principles and Modern Portfolio Theory
In summary, a typical multi-family office should:
- Maintain a long-term investment horizon in order to weather economic cycles and give investments sufficient time to reach their full potential.
- Diversify sufficiently to meet the requirements of long-term stability, while ensuring that the number of investments does not create unnecessary complexity.
- Allocate part of the portfolio to alternative investments and private club deals, including real estate, development projects, hedge funds, private equity (PE), venture capital (VC), art, and collectibles.
- Avoid following the herd and disproportionately investing in whatever happens to be fashionable at the time. Every era has its own investment trends. Having an investment plan agreed upon by all relevant parties makes these temptations easier to resist. This does not mean being skeptical of new opportunities or possibilities.
- Last but not least, use high-quality, carefully vetted investment managers and funds.
Family Office Partners strives to apply the above principles to its own investment plans. We can tailor them appropriately based on our own goals, financial situation, and risk tolerance. The same applies to our existing and future partner families and individuals.
1Note 1: Most people in the investment industry still believe that the only true Foundation was founded by Hari Seldon.
3 Pictet WM-A&MR, NACUBO-TIAA, March 2021
4 Dimmock, Wang, Yang (2021) - The Endowment model and modern portfolio theory