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Delivering Returns, Managing Expectations - The Outsourced CIO's Task

Tom Burroughes, Group Editor , February 1, 2019

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This news service recently spoke to Hirtle Callaghan, an outsourced chief investment office business, about its market views and approaches, how it treats clients, and its place in the wealth ecosphere.

The role of the outsourced chief investment office is an important one in today’s family office and wealth management sector. Given the cost constraints and need to tap expertise efficiently, the outsourced CIO model has its obvious attractions. A prominent organization in this space is Hirtle Callaghan

FWR talks to Mark Hamilton, the chief investment officer at the firm, about his views on markets, helping clients and guiding expectations about returns. 

What is your view of the case for holding risk assets such as equities right now?
We are neutral in our risk and equity positioning today. Assessing the current investment environment, we see a mix of reasons for optimism and caution that leads us to a balanced view. On the positive side: equity valuations look relatively attractive versus a year ago, borrowing costs are still low, and the banking system is well-capitalized in the event of a possible downturn. At the same time, there are reasons for caution: earnings growth is slowing down from its recent peak, financial conditions are tightening, the Federal Reserve may tighten further and uncertainty around the trade dispute with China remains high. So we are not overweight or underweight equities, but at long-term targets reflecting our neutral view.

A few things could change to make us more optimistic. Until recently, the Fed was on a very clear path of raising its policy target rate, which has been seen by markets as a headwind. However, if the Fed were to react to slowing growth by pausing its rate hikes, we think this could be positive for risk assets.

Trade is the big wild card for risk assets. The uncertainty around the outcome of trade negotiations between the US and China combined with the inflammatory political rhetoric has been negative for markets. If the tone of the negotiations improves or we reach a trade deal, we would expect markets to respond positively.

The bottom line is that we view the investment environment as being relatively balanced and events related to the Fed and trade could swing it in either direction.

For a cautious client, for example, what would be your recommended exposure, if wealth preservation is the priority?
At a minimum, in order to preserve wealth, families must grow their portfolio at the level of taxes, inflation and spending. The key is to understand what that means for each family.

Our approach is to customize each family member’s asset allocation depending on their priorities and circumstances; therefore, there is no rule of thumb “recommended exposure.” No matter the individual circumstance, we believe diversification is key to preservation. On one level, this is just common sense; as the old adage says, “don’t put all your eggs in one basket.” Putting this in practice, however, is more complicated.  A traditional way of investing is to diversify among various asset classes, such as public equity, bonds, real estate, hedge funds, etc. We believe that it is more useful to think about the role that different asset types play in portfolios.

We group assets into three categories: growth, income and diversifiers. Growth assets, which include all forms of equity, allow investors to participate in the growth of businesses. Return expectations are high, and with that comes a higher level of volatility. For most investors, growth assets are the dominant source of volatility risk. Investors mitigate some of that exposure by investing in income assets, or assets that have a steady, consistent yield component. Income assets provide ballast to portfolios, providing low volatility and low correlation to equity risk. The last category, diversifiers, encompasses strategies that are somewhere in between equities and fixed income, including various types of hedge funds, high yield and opportunities such as private credit. They have a moderate correlation to equities, and more moderate volatility. When markets declined in the fourth quarter, we saw how powerful diversifiers can be; hedge funds were down less than 4% compared with global equities down over 9 per cent.

The family’s required return to maintain purchasing power will drive the construction mix between growth, income and diversifiers.  We must also assess if the family’s required level of risk (to meet their objectives) is aligned with their willingness to take risk. Drawdowns, while not permanent, can cause anxiety for families. We want to ensure that the investment plan is one that they will be able to stick with through all market environments. Education is a significant part of this process.

Can you go into a bit more detail about the process you go through in talking to a client, such as a high net worth person, family office, etc, in what they want to achieve with their money? How do you start such a conversation?
There is no substitute for in-depth conversation in setting up a successful long-term partnership. We need to get to know each person we work with personally and understand what they hope to achieve.

This process begins with a conversation around a series of questions: How do they define success? What is the intent behind the capital? Philanthropy? Lifestyle support? Generational preservation? What would keep them up at night? Each family has a unique story of how they created their wealth and what it means to them. Ultimately, we want to help our clients translate their time horizon, spending needs, willingness to take risk and any other considerations, such as tax and estate planning, into a long-term investment plan; doing this well requires genuine curiosity and active listening.  

A big part of asset allocation is understanding risk. It can be said that some investors conflate risk and volatility but that should not be the case. How do you frame the conversation about risk with a client?
Risk means so many different things to people even though, as you point out, it is often thought of simply as volatility. Going back to our planning process, we collaborate closely with families to make sure we understand what they define as risk. Is it a bad quarter or a permanent loss of capital? How well equipped are they emotionally to withstand the vagaries of the market? We try to define risk up front as we develop an investment plan so that our investment recommendations are in line with their true definition of risk.

One evolution in our process last year was the creation of a questionnaire to help start a conversation around risk. We ask a series of thought-provoking questions to get to the heart of what matters to families and how they define risk. It is a useful jumping off point, especially when there are multiple family members, or generations, with different opinions. We don’t always get everyone on the exact same page, but more often than not we are able to build consensus which is very helpful in the long term.

Do your clients mainly invest in domestic US assets or do you go global if required?
We believe firmly that our edge comes from maximizing breadth of opportunities, and the best opportunities are sometimes outside of the US. Most families for whom we serve as CIO start with a global mandate unless there are specific circumstances that require them to invest only in US assets.

While our starting point for an investment plan is to target a global exposure to equities – approximately half of the equity exposure is in the US and half international – over time we will over or underweight US equities versus international equities depending on where we see the opportunities and risks in the world. In contrast, US exposure may be much higher in other asset classes, such as within fixed income where municipal bonds offer significant tax advantages.

Are there mistakes or biases in how clients think about investment that you see repeating themselves and that you would like to mention?
When it comes to investing, research indicates humans consistently demonstrate several types of destructive behavior, so it is critical that we help families and each other adhere to the discipline of investing. One common bias is to project recent trends; this is when investors expect current conditions to extend into the future, often causing them to buy high and sell low. When times are good, it is easy to ride the wave of optimism and buy into what has performed best just before the tide turns. Likewise, it is all too easy to extrapolate out gloom and doom and sell just as the markets bottom out. Other examples include ascribing a cause to random events and anchoring to the first information received. Our job as CIO is to help investors avoid these mental traps. We establish a concrete investment plan in in partnership with families that helps us to stay focused on their long-term goals and avoid being sidelined by short-term timing mistakes.

Have client expectations about returns adjusted after several years of very low interest rates? Do you think the wealth industry in general has improved in managing clients’ expectations?
As we talked about above, humans tend to have recency bias, projecting current circumstances into the future. Investors have been used to a period of very low interest rates which until very recently encouraged a preference toward return-seeking assets, such as equities, over low-yielding bonds. Coming out of the Great Financial Crisis, global central banks engaged in quantitative easing (QE), purchasing bonds with the explicit intent of keeping rates low to encourage borrowing and stimulate growth. After a decade of QE, central banks such as the Fed and the ECB are reversing course and reducing monetary stimulus. It is a very reasonable expectation that bond yields will rise over time as central banks increase policy rates and reduce their QE programs. In the US, we have already seen the Fed raise its interest rate target seven times over the course of the past two years from near zero to a range of 2.25 per cent-2.5 per cent. As policy rates have gone up, so have the yields on corporate debt: high yield bonds started 2018 yielding under 4 per cent and ended the year over 5 per cent.

As rates continue to increase, they will not provide the same tailwind for equities as they did over the past decade. I cannot speak to how others in the industry are managing expectations, but we are communicating our expectation to clients.  Our medium-term asset class expectations also reflect this viewpoint.

How much do conversations in asset allocation involve alternatives (real estate, hedge funds, private equity, commodities, infrastructure, etc)? Have you seen a definite change in recent years?
One of the cornerstones of our investment philosophy is that maximizing breadth of opportunity leads to the best long-term results. We look across the entire passive to active spectrum and view allocating to alternative investments, the most active component of that spectrum, as an essential component of achieving breadth. Not all alternatives achieve breadth in the same way; for instance, hedge funds should be more defensive and balance out equity risk, while private equity is a “super-charged” form of equity that can enhance returns.

In the past decade in which equities had very strong performance, because of the recency bias mentioned earlier, it has been easy for investors to disregard the benefits of investing in a diversified portfolio which includes alternative investments. However, this past quarter, where our hedge funds were a bright spot relative to equities, was a reminder that there are periods of time when you need diversification or in a lower return environment private equity might be an important return component in meeting objectives. We believe that many families, whether cautious or optimistic, can benefit from the addition of some form of alternative investments in their portfolio.

If there is a differentiator to how Hirtle C operates as a business, what would you say that is?
Hirtle Callaghan was created 30 years ago to function most similarly to a family’s internal investment office. We purposely operate free from conflicts of interest like selling products on which we could get paid a fee. Our conflict-free model ensures that our interests are in complete alignment with the families we serve. We are incentivized to give them our best advice and nothing less.

Moreover, we operate as an extension of a family’s staff, dedicating time and resources to customizing total investment solutions to meet each family member’s goals. We often work closely with multiple generations and are a valuable resource to children who are just learning about investments. Viewing ourselves as true partners with each family, sitting on the same side of the table, is a critical differentiator in industry that is still rife with conflicts.

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