Danger: high risk area

Last year was the year that diversification didn't work. Traditional investment theory was turned on its head as the majority of asset classes fell in unison. For many family offices, diversification was the cornerstone of their risk management approach and few succeeded in their key goal – the preservation of capital. In light of the new investing environment, are family offices changing the way they approach risk management?

The recent Merrill Lynch/Campden family office survey showed that many family offices were hit as hard as retail or institutional investors in spite of their wealth preservation remit. Gary Dugan, chief investment officer of Merrill Lynch Global Wealth Management for EMEA, said that the problem tended to be an over-exposure to leveraged hedge funds, which had been introduced into family office portfolios as a lowly correlated asset but struggled with poor performance and illiquidity.

With longer time horizons, family offices had tended not to need to pay a premium for liquid investments, but all illiquid investments were hammered in the recent market rout.

Yet in spite of this, 74% of the family offices surveyed said they have not changed the way they handle risk. Dugan thinks this looks complacent, as even the best risk systems have been challenged over the past few months. He says risk management will need to change: "Generally, at the moment, risk management is still just part of someone's role. It needs to have one dedicated person at least, but this will increase costs."

They may not have changed their risk processes, but the survey found that they have changed the make-up of their portfolios significantly. For example, average equity exposure has been reduced from 35% to 18%. It is difficult to know whether this is as a consequence of a robust risk management process or whether the shift is a result of markets falling. The low weighting in fixed income found by the survey suggests that the asset allocation changes may not have all been deliberate. Dugan says: "I'm surprised fixed income is only 10% of family office portfolios. Government bonds have been the only diversifying assets over one to two years."
 
While the survey may show that the basic risk processes for family offices haven't changed, there have undoubtedly been new risks to assess and family offices have been more focused on risk management. The new risks to cash have been the most important. Simon Paul, director, wealth management, at multi-client family office Sandaire says: "We've been conscious over the past year to 18 months of a whole new set of risks for anyone who is invested in financial assets. Three years ago, if you had a deposit in a bank, no-one would have questioned its safety. That changed 18 months ago when we started to question the safety of both savings accounts and cash funds." Paul took his clients out of cash funds and into T-bills and Gilts, a move, he says, would not have been necessary at any other point in the past 20 years.

Arthur Lancaster, group director at multi-family office Boston Ltd, agrees that the safety of cash has become a new focus. He adds: "We have gone to a lot of effort to keep cash safe and we are constantly asking ourselves whether we can make it safer. This means looking at counterparty risk, and what an AAA-rating really means. Money market funds, for example, benefit from being diversified, but can still lose money."

Paul also says that the Madoff scandal brought due diligence into sharp focus. He adds: "We have always done due diligence, but it has become more time-consuming. We have to spend that bit longer choosing what to do with our clients' money."

Lancaster says there has been a move to more transparent investments; "Clients want to be able to understand what is happening with their money. Times like these force us to understand the meaning of money from a client point of view." He has gone back to basics with his clients – what is the money for, what are the assets, what income is needed, what is the acceptable level of risk. At the moment, there is a premium for liquidity and safety. Lancaster says that many income seekers will not cope with the low savings rate over the long term and it is a question of trying to match assets with liabilities.

When it works, risk management can save a lot of money. Chris Wyllie, partner and head of portfolio management at Iveagh, the Guinness family office, says he is pleased with the way its risk management system has held up. He says a lot of early effort was put into building a robust system: "The founder of the family office always wanted proper risk management. It was never sufficient to go through a rudimentary risk assessment and simply stick on a risk label. You always need to manage assets according to the investment climate."
 
Wyllie says that the risk management system gave a clear signal in November 2007 to take significant risk off the table and equities were reduced from 60% to 10%. He adds: "This system includes market intelligence and we had specialist credit managers saying that there was a huge discrepancy between the bond and equity markets. Our valuations measures were telling us that equities weren't cheap. Everything was flashing red. It was an automatic decision. Our risk management is done decisively or not at all."

The group lost 5% last year having reallocated to bonds, cash and long/short hedge funds. Wyllie says: "We have preserved the vast majority of capital and this means we haven't got to double our money to get back to where we started."

Lancaster believes there is also a danger in being too conservative after the event. He adds: "At some point, investors will have to try and rebuild wealth and win back what has been lost. To do this, they will need to take risk." If family offices are frantically moving into safe assets without the proper risk management procedures in place, they risk missing the bounce.

Wyllie says that the signs coming from their risk management systems now are much less clear, but with no strong buy signal for the time being he is remaining defensively positioned. He adds: "The debate is whether equities are cheap or outlandishly cheap and they probably have to be outlandishly cheap given the economic climate."

Family offices have had to manage new risks and should question their existing risk procedures if they did not lead them out of risk assets towards the end of 2007. It seems that a number of family offices have been caught, in Warren Buffet's words, "swimming naked" by crediting diversification with too much power to preserve capital. Even those family offices with robust procedures have had to re-examine how they treat risk. It seems likely that with a number of family offices sitting on large falls, risk management will be a priority over the next few years.