In previous discussions, we have highlighted several aspects of governance within family offices, particularly in relation to investment management. At the heart of investment governance is a vital document that outlines investment goals, objectives and strategies.
In this article, we will explore the importance of this vital document that determines the success of family office investments.
Understanding the Family Office Landscape
Family offices are designed to manage the wealth of a single family, often spanning multiple generations, each with distinct financial needs, varying risk tolerances, and a wide range of long-term objectives. These objectives can range from wealth preservation and risk adjusted growth, to philanthropic goals, business interests, and provisions for future generations.
Despite their complexity, family offices often operate with less formal structures compared to other institutional investors. From our experience, this formality manifests in several ways:
- Lack of documented investment processes: Investment decisions may be made on an ad-hoc basis, without a clear framework.
- Over-reliance on personal relationships: Investment managers may be selected based on personal connections rather than objective criteria.
- Insufficient monitoring and reporting: Performance may not be regularly or rigorously evaluated.
- Undefined roles and responsibilities: It may not be clear who is responsible for making investment decisions, leading to confusion and potential conflicts.
This lack of structure can lead to several negative consequences, including non-alignment and inconsistent investment strategies, conflicts of interest, increased risk-taking, or even investment decisions that erode the family’s wealth over time.
What is an Investment Policy Statement?
This is where the Investment Policy Statement (IPS) comes into play. The IPS serves as the foundation for investment activities in a family office. It is a highly customised document that is uniquely tailored to the preferences of the family. Referring to the evergreen report “Best Governance Practices for Investment Committees” released by the Greenwich Roundtable and “Elements Of An Investment Policy Statement For Individual Investors” released by the CFA Institute, as well as our own experience in helping family offices create sound investment governance, a well-crafted IPS should typically include:
1) Purpose: This section clearly articulates the reason for the family office’s existence and the investment portfolio. It defines the beneficiaries, the time horizon over which the investments will be managed, and the overall goals the portfolio is intended to achieve. A clear purpose guides all subsequent policy decisions.
2) Objectives: Building upon the stated purpose, the objectives section outlines the specific, measurable, achievable, relevant, and time-bound (SMART) goals for the investment portfolio. These typically include both return objectives (e.g., achieving an average annual return of 7% above inflation) and risk objectives. Clearly defined objectives provide a benchmark against which the portfolio’s performance can be evaluated and ensure that risk-taking is aligned with the investor’s capacity and willingness to bear it.
3) Asset Allocation: Often considered the most significant driver of long-term investment returns, this section details the strategic framework for how the portfolio’s assets will be distributed across different asset classes. A comprehensive asset allocation strategy often includes four crucial elements:
- The Policy Portfolio: The ideal long-term target asset mix, specifying the allocations to various asset classes such as equities, fixed income, real estate, and alternatives.
- The Benchmark Portfolio: This serves as a standard against which the actual portfolio’s performance will be measured.
- The Actual Portfolio: This refers to the current composition of the investment holdings. It will naturally deviate from the policy portfolio over time due to market movements and investment decisions.
- Benchmarking: An ongoing process of comparing the actual portfolio’s performance against the benchmark portfolio.
4) Governance Framework: This section sets out the structure for managing the investment process. Key elements include:
- Fiduciary Responsibility: Families should outline the legal and ethical duties of those responsible for managing the investment portfolio. It clarifies the principles of prudence, loyalty, and diversification that must guide their actions. By clearly defining fiduciary responsibilities, the IPS promotes accountability, transparency, and adherence to the highest standards of care in managing the assets.
- Establishing Decision-Making Authority and Responsibilities: Clear roles and responsibilities must be defined for key actors involved in the investment process. This includes specifying who holds the authority for determining investment policy, who is responsible for its execution, and who is tasked with ongoing monitoring. Furthermore, this subsection should outline the process and responsibility for engaging and, when necessary, discharging external advisors, such as money managers and consultants.
- Review and Adaptation: This section also details the procedures for the periodic review and updating of the IPS. This ensures the document remains relevant and adaptable to evolving investor circumstances and changing market conditions.
The above allows for a structured and accountable approach to the comprehensive oversight of the investment portfolio.
5) Other Provisions: This section includes supplementary policies and guidelines that govern the day-to-day management of the investment portfolio, deemed necessary by the family office. Examples include:
- Manager Criteria: Outlines qualifications, experience, and selection process for any external investment managers that may be hired.
- Constraints: Defines any limitations or restrictions on the types of investments that can be held (e.g., ethical considerations, sector limitations) or specific risk parameters.
Why does your Family Office need this?
A well-crafted investment policy statement may prove even more essential today than in previous environments, given recent periods of market volatility and anticipated lower investment returns over the market cycle. The IPS offers several key benefits:
Alignment
- By providing a clear, structured framework, it ensures consistency and discipline in investment decisions, reducing the impact of emotional biases and enabling more rational strategies.
Risk Management
- It helps manage risk by setting clear parameters that align with the family’s risk tolerance through diversification. It also promotes regular monitoring and reporting to evaluate performance.
Dispute Resolution
- In case of disagreements, the IPS provides a documented reference point, which can facilitate resolution by clearly outlining objectives and guidelines.
Execution
- An often overlooked and imperative aspect is the importance it plays in the human capital strategy for the investment team. An IPS will help guide the fundamentals of the type of investment talent and specialization needed, how their success will be defined and measured. Lastly and perhaps most importantly, how they will be compensated, retained and aligned with the interest of the family office.
There has been considerable talk about the “professionalization” of family offices in recent years. However, there is little guidance on how to achieve this. We believe the IPS is a crucial first step in the professionalization journey. Our “Family Office Maturity Model” outlines the stages of evolution, from the initial ‘Embedded’ phase, where personal and business affairs are intertwined, to the ‘Mature’ stage, characterized by structured governance and board-level oversight. The IPS plays a foundational role in this transition.
For further details, you can view the “Agreus Family Office Maturity Model” here.
Implementing and Maintaining the IPS
Developing and implementing an IPS is a collaborative process that should involve key stakeholders, including family members and trustees. It is essential to ensure that all parties understand and are aligned with the policies outlined in the document. At the same time, we understand that developing an IPS may not be a typical exercise for many family offices. It demands significant thought, a deep understanding of market dynamics, and familiarity with core investment principles and practices. Therefore, we highly recommend engaging experienced external advisors and hiring seasoned Investment professionals in the process.
The IPS is not a static document. It must be reviewed and updated regularly to reflect changing market conditions, evolving family circumstances, and any changes in the family’s objectives or risk tolerance. Ongoing reviews will ensure that the IPS remains relevant and effective in guiding the family’s investment strategy.
Read the full article here
