12 March, 2020
The scenario is always the same: we feel confident that things are under control or, at least, manageable. Still, we get caught by a black swan that no one can really predict. This time in the form of a virus. A bad one which creates havoc. Not so much because of the number of people infected but rather the impact it can have on national health systems, thus social stability.
This has led to market crashes reminiscent of the 2007-2008 crisis. The S&P 500 alone has lost over US$5 trillion in the last few weeks (coronavirus outbreak and oil price war). Central banks implement last minute policies to absorb effects and governments open their cheque books. Deja-vu, isn’t it?
What are the implications for long term investors, of which Family offices whose fundamental function is to preserve capital?
Many say they do not care about risk management as they invest with a long term perspective, thus expecting things to continue to increase as they always have. Since the beginning of the week, all have been busy scrambling to figure things out: capital losses, impact on cash-flow and the ability to maintain commitments. Should this diligent reaction take this long? Would you rather spend time on collecting data or make a decision on how to protect your portfolio? How efficient is Excel for collecting data and calculating the right indicators?
This also brings the notion of diversification back into question. A considerable amount of family offices are not diversified because they want to stick with what they know best. Is this approach a natural and reliable hedge in a period of increased volatility? Or does it, in fact, prove to be quite speculative as diversification is the only viable insurance policy that long term investors have?
Even better, diversification is the only free lunch in finance. So why ignore it? Portfolio construction is a necessary step to ensure that a portfolio is well diversified. Diversification and portfolio construction are the two faces of the same coin. It is about deciding the weight that each asset should have to protect the ability to yield targeted returns. Unlike what many think, it is not a discipline that only speculators should worry about. It applies to all investor types as it is about getting the right level of diversification to achieve risk-return profiles and preserve capital.
Finally, you may wonder if this crisis is a catalyst for the NextGen. It shall help improve governance for three reasons.
The first one being the necessity to obtain a thorough and accurate 360 degree view across all assets. This is something you need for the NextGen to take over. How can you transmit and manage something you do not measure?
The second one is about internalising the ability to apply robust finance principles to meet your needs. When you master this, it is easier to create multiple portfolios that meet multiple constraints from a central model portfolio. It is an efficient and easily automatable approach when a family grows with different generations coexisting together.
The third and final reason is more obvious. A crisis at this scale forces current principals and family office executives to upgrade their operational processes and embrace digital technologies that NextGen expect to have and benefit from.
So, how reliable is Excel in a period of crisis? Not quite. Good news: digital technologies exist to reduce error, offer security and scalability. A cloud-based software brings the flexibility needed to ease adoption. However, it is crucial to select one with the right algorithm and that is developed by experienced risk practitioners who understand your needs.