Reading 4.5

Question 1

What is considered an ultra-high-net-worth individual or group of individuals?

Answer 1

with over $30 million in assets

Question 2

In 2018, about __ to ___ family offices in the U.S. and about ___ worldwide managed over ___.

Answer 2

3,000 - 5000

10,000

4 trillion USD

Question 3

There are generally two types of FOs:

Answer 3

1. Single-family office (SFO) or dedicated family office
   * An SFO serves one UHNW individual or family. Dedicated family offices are generally operational at $1 billion of assets under management and cost about 60 basis points of AUM per year to run.
2. Multi-family office (MFO)
   * MFOs pool assets of and offer services to a few UHNW families. MFOs typically start as SFOs and later add other families; they also start with several families. Wealthy individuals or families with less than $1 billion likely use MFOs.
   * MFOs can benefit from economies of scale, share operating expenses and back-office administration, and pool investment ideas.

Question 4

A key benefit to FOs is providing a consolidated wealth management and accounting service. Specific goals are various and generally include the following 3:

Answer 4

1. Maintain a lifestyle (e.g., fund purchases of homes, cars, private jets, and art).
2. Preserve or grow wealth for futures generations.
3. Maintain charitable goals (e.g., using a foundation).

Question 5

4 BENEFITS OF FOS VS. PRIVATE BANKS & TRADITIONAL ASSET MANAGERS

Answer 5

1. Central source for financial management - An FO is typically a key source of information and advice on all family financial affairs.
2. Confidentiality
3. Dedicated staff - FO’s staff is dedicated exclusively to the goals of the UHNW individual/family, with detailed knowledge of family members (e.g., personalities, specific objectives, risk tolerances, spending needs, and philanthropic interests).
4. Consolidated capital - keeps family money consolidated in one place. However, this can become challenging with more generations and their specific goals.

Question 6

What are the perceived benefits for Families with FOs?

Answer 6

Question 7

Question 1: How does a Family Office (FO) differ from the endowment model in terms of structure?

Answer 7

Answer: Unlike the standardized endowment model, FOs are highly customized to meet the specific needs of each family.

Question 8

Question 2: What are some potential drawbacks of family members directly managing the FO’s investments?

Answer 8

Answer: Family members might lack the training and experience in managing assets and portfolios effectively.

Question 9

Question 3: Describe the variety of investment strategies and structures used by Family Offices.

Answer 9

Answer: FOs can differ in terms of asset allocation, team size, performance benchmarks, infrastructure (in-house vs. outsourced), hedge fund investments, private equity/real estate investments, and internal vs. external management.

Question 10

Question 4: Can Family Offices manage investments for clients outside the family?

Answer 10

Answer: Yes, some FOs manage capital for external clients, but this adds regulatory burdens and increases operating costs.

Question 11

Question 5 (Optional): How does the SEC define a “family member” in relation to Family Offices?

Answer 11

Answer: The SEC defines a family member as any member of the direct bloodline of the founder and their spouses, extending up to 10 generations (and spouses) related to a designated ancestor. In-laws and their relatives are not automatically included.

Question 12

Question 6 (Optional): What are some of the challenges Family Offices face when accepting external clients?

Answer 12

Answer: Accepting external clients can lead to increased costs, compliance burdens, and potential conflicts with family members who may not want to share investment strategies with outsiders.

Question 13

Generations Served by SFOs in % terms?

Answer 13

Question 14

Card 3 (Front): How can executives diversify their concentrated stock positions?

Answer 14

Card 3 (Back): Some executives use completion portfolios that invest in assets with low correlation to their company stock, such as real estate or technology stocks if their main holdings are in healthcare.

Question 15

Card 4 (Optional, Front): How can option collars help executives hedge their concentrated stock holdings?

Answer 15

Card 4 (Optional, Back): Option collars involve selling calls (limited upside) and buying puts (downside protection) to reduce risk and potentially delay capital gains taxes.

Question 16

Card 5 (Optional, Front): What is a potential drawback of using loans secured by company stock as a liquidity source?
Card 5 (Optional, Back): Losses can occur if the loan proceeds are invested in risky assets.

Answer 16

Card 5 (Optional, Back): Losses can occur if the loan proceeds are invested in risky assets.

Question 17

Front: How do investment approaches differ between first-generation wealth and later generations?

Answer 17

Back: First-generation wealth focuses on absolute return benchmarks (like a fixed % above a risk-free rate) and diversification from concentrated holdings.
They invest in lower-risk assets like bonds and may limit private equity.

Later generations prioritize wealth generation through long-term capital gains, considering tax implications and aiming for an efficient frontier with optimal after-tax returns.

Question 18

Difference in Asset Allocation for an FO and an Endowment Fund?

Answer 18

Question 19

3 levels of liquidity defined:

Answer 19

1) Liquid assets are assets that can be sold in less than three months at non-discounted prices.

2) Illiquid (or chunky) assets are assets that can be sold within one year at discounted prices.

3) Semi-liquid assets are assets that are sold between three months and one year.

Question 20

An issue with the FO portfolio’s higher private asset allocation is that it may result in

Answer 20

a highly illiquid portfolio

Question 21

Liquidity Profile of an FO and a University Endowment Fund

Answer 21

Question 22

While endowment investment portfolios are driven by beta drivers (i.e., products that provide systematic risk premiums), returns of many asset classes and FOs are driven by FOUR key macroeconomic factors.

Answer 22

1. Real return
2. Inflation (realized and expected)
3. Growth
4. Risk premium

Question 23

Macroeconomic Drivers of U.S. Equity Returns in % terms

Answer 23

Question 24

Macroeconomic Drivers of Conservative FO Returns in % terms

Answer 24

Question 25

cash dividends paid to FOs are generally taxed at a higher ordinary income tax rate than ___ distributions.

Answer 25

private equity fund

Question 26

How are short term capital gains taxed?

Answer 26

Short-term capital gains are typically taxed at the investor’s ordinary income tax rate, which is higher than the tax rate for qualified dividends (and long-term capital gains).

The highest ordinary income tax rate in the U.S. (excluding state taxes) is 37%.

Question 27

The highest long-term capital gains tax rate in the U.S. is __%.

Answer 27

20%

Question 28

What is the benefit of Section 1256 contracts, which include instruments such as futures contracts?

Answer 28

For tax purposes, 60% of gains of Section 1256 contracts are considered long-term capital gains and 40% are short-term gains

Question 29

FOs can increase their tax efficiency by selecting three types of hedge funds:

Answer 29

1) Long-term investment horizon: Funds with strategies like equity long/short or event-driven tend to focus on long-term holdings (over 1 year) which qualify for potentially lower capital gains tax rates.

2) Section 1256 security investments: These investments (e.g., futures contracts) offer a tax advantage with 60% of gains taxed as long-term capital gains.

3) Tax-efficient managers: Reviewing a hedge fund’s Schedule K-1 (tax document) helps identify managers with a high proportion of long-term capital gains in their total return.

Question 30

What are lifestyle assets or passion assets?

Answer 30

assets that are purchased based on the lifestyle preferences or passions of family members (e.g., art, cars, boats, and planes).

Question 31

Which 2 indicies track ART returns?

Answer 31

1) Repeat sales index estimates returns using two repeat sales of a piece of artwork.

2) Rarity premium index measures a rarity premium as the difference between the realized price paid at auction and the estimated price set by dealers or an auction house.

An issue with this index is that rarity premiums are based on subjective estimated sales prices.

Question 32

Advantage and 4 Issues with Repeat sales index

Answer 32

An advantage of the index is that the use of pairs of prices for the same artwork removes the issue of uniqueness as a bias in the index.

1. The time period between the pairs of trades can be several years.
2. Museums buy a great deal of artwork, which results in removing the art from the trading market (sometimes permanently).
3. The index does not account for the large number of single art transactions.
4. The index does not include private transactions that make up close to half of all art transactions.

Question 33

Despite the arguments for art as an asset class, some argue against it for 5 reasons:

Answer 33

1. Art has no systematic risk premium that can be used for risk budgeting, which makes it difficult to determine an efficient frontier that includes art.
2. Artwork is heterogeneous, with each piece being unique and defined by physical, intangible traits.
3. Artwork does not generate any cash flow, therefore its present value cannot be determined using the discounted cash flow model.
4. The volatility of artwork is difficult to measure since infrequent sales of artwork prevent the construction of a distribution of returns.
5. Art is rarely traded and thus illiquid. It is typically purchased for enjoyment, not for capital gain.

Question 34

How do some investors offset the cost of storage of art?

Answer 34

Some art investors offset these costs by leasing their art. Lessees of art include corporations (that benefit from tax-deductible lease payments) and art investors who either display art that they cannot afford to buy or want to live with the art for a period of time before deciding to buy it. In some cases when investors want to purchase the leased art, the lessors may credit all or part of their lease payments toward the purchase price.

Question 35

Where is Artwork is often stored

Answer 35

In free ports, which are specialized storage facilities used by UHNW
individuals to store valuables.

Repositories for art are typically controlled for factors such as light and climate.

Question 36

In addition to wealth management services, many FOs provide concierge services such as 6 listed:

Answer 36

• Personal shopping
• Art curation and purchase
• Travel arrangements
• Entertainment and sporting events
• Purchase and maintenance of transportation assets
• Arranging medical appointments

Question 37

The full-service FO provides the following 9 services:

Answer 37

1 Accounting
2 Asset Management
3 Concierge
4 Education
5 Estate Planning
6 Fiduciary
7 Governance
8 Philanthropy
9 Taxes

Question 38

2 general type of governance structures of a FO and what are the pros of each?

Answer 38

1Formal: Similar to universities, a board with mostly family members meets regularly to review and approve investments.

Pros: Thorough process with documented proposals, facilitates discussion and prioritizes family interests.

2) Informal: One family member, usually the wealth creator, controls decision-making with a dedicated investment officer.

Pro: More flexible due to single decision-maker.

Question 39

There are four key reasons for loss of family wealth over generations.

Answer 39

1. Dilution of family wealth as the number of descendants increases over generations
2. Lack of skill or interest in the family business by later generations
3. Ill-prepared later generations with respect to being productive and managing family wealth
4. Focus on philanthropy so assets are not willed to descendants

Question 40

___ % of family businesses do not last three generations and less than __ % of families maintain their wealth across three generations

Answer 40

92% & 30%

Question 41

Family estate planning refers to

Answer 41

planning the distribution of a family’s assets in anticipation of the death of an earlier generation; and involves considering the family’s goals, number and type of beneficiaries, tax liabilities, insurance strategies, and donations outside the family.

Question 42

Describe the difference between Charity vs. Philanthropy:

Answer 42

Charity:
- Focuses on short-term solutions to immediate needs, like providing food and shelter.
- Doesn’t typically demand accountability from recipients.

Philanthropy:
- Aims for lasting change, like offering job training to help people escape homelessness.
- Often involves ongoing engagement to maximize impact.

Question 43

Difference between Negative and Positive screening?

Answer 43

1) Negative screening involves avoiding investments considered to have a negative impact on social and/ or environmental issues (e.g., related to pollution or unfair employment practices).

2) Positive screening involves making investments that have a positive effect on social and/ or environmental issues (e.g., producing goods, high wages, and good working conditions).

Question 44

What are the 3 different approaches to private impact investing?

Answer 44

1) Impact First: This approach prioritizes the social or environmental benefits of the investment. Investors may accept lower financial returns or even forego them altogether if the project addresses a critical social need.

2) Finance First: This approach prioritizes achieving strong financial returns. Investors first identify opportunities with competitive risk-adjusted returns, and then consider the social or environmental impact within those options.

3) Impact Alpha: This approach is based on the idea that companies with strong social responsibility outperform financially in the long run, while companies with poor social practices underperform. Investors aim to capture this “impact alpha” by investing in companies that are making a positive social or environmental impact.

Question 45

10 advantages of family offices in context of second- and later-generation FOs (after the family operating company has been sold).

Answer 45

1) Aggressive Investments: They can invest in riskier assets like private equity due to high tolerance for risk.

2) Long-Term Investments: They can hold onto investments longer to capture better returns.

3) Direct Deals: They can invest directly in companies for better returns and control.

4) Faster Decisions: They can make investment decisions quicker than larger institutions.

5) Family Goals: They manage investments considering each family member’s needs.

6) Aligned Interests: They structure investments to benefit the entire family and avoid conflicts.

7) Potentially Higher Returns: Their structure allows for cost savings and potentially higher returns.

8) Better Risk Management: They can centrally manage risks across all investments.

9) Cost-Effective Services: They can offer various services to the family at a lower cost.

10) Lifestyle Assets: They can consider lifestyle assets when making investment decisions.

Question 46

Global Wealth Pyramid

Answer 46

Question 47

Difference between multi-family offices (MFOs) and private wealth management (PWM) firms:

Answer 47

1) Similarities:
- Both cater to wealthy families (UHNW).
- Both offer a range of services beyond just investments (multi-disciplinary approach).

Differences:
- Structure: MFOs are independent firms, while PWM firms are backed by larger financial institutions.
- Resources: MFOs may have less access to resources like investment banking compared to PWM firms.
- Focus: MFOs may be more customizable to specific family needs, while PWM firms may offer a more standardized service.

Question 48

T. Davidow’s “Goals-Based Investing” book describes 6 components that comprise a typical framework for wealth management teams:

Answer 48

1) Develop a financial plan: Gather client information about goals, risk tolerance, and needs.

2) Review trust and estate issues: Discuss estate planning, charitable giving, and tax strategies.

3) Develop an asset allocation: Create a long-term investment strategy using different asset classes.

4) Implement portfolio construction: Choose specific investments to match the asset allocation plan.

5) Monitor progress: Regularly track performance against the client’s financial goals.

6) Become a behavioral coach: Guide clients to make rational investment decisions and avoid emotional biases.

Question 49

As barriers have been lowered to improve access to financial services, the wealth management industry has expanded to serve more investors below the UHNW level, such as:

Answer 49

1) mass-affluent investors (i.e., with investible assets of $100,000 to $1 million)

2) high-net-worth (HNW) investors (i.e., with $1 million to $30 million).

Question 50

Definition and 3 main characteristics of Wirehouses:

Answer 50

A wirehouse is a large financial firm offering more standardized investment and financial services to wealthy individuals (mass-affluent and high-net-worth). Unlike private wealth managers, wirehouses typically arent fiduciaries.

1) Target Clients: Mass-affluent and high-net-worth individuals (less wealthy than those served by PWM firms).

2) Services: Investment and financial services similar to, but potentially scaled-down from, private wealth management firms.

3) Fiduciary Duty: Unlike PWM firms, wirehouses typically don’t act as fiduciaries, meaning they may prioritize the firm’s interests over the client’s.

Question 51

PWM firms use three general service models:

Answer 51

1. Digital advice
2. Financial planning and investment management
3. Comprehensive PWM

Question 52

What is a roboadvisor and what are the main tools used?

Answer 52

It is a financial advisor that provides internet-based portfolio management and
advisory services, typically with no human intervention.

The standardized investment management services use low-cost, passive investment products (e.g., index funds) and automated asset allocation and rebalancing tools

Question 53

3 pros and cons of ROBOADVISORS

Answer 53

PROS:
1. Financial advice to a large subset of the population that previously would not have had access to a financial advisor.

2. Automated investment services that enable investors to “set it and forget it.”
3. Lower barriers for clients to invest.

CONS:
1. Most provide no human interaction with a financial advisor, thus providing no customization for client objectives.

2. Typically designed for low-net-worth and non-sophisticated clients who are starting out, thus leaving out opportunities for HNW clients and those with more complex financial situations.
3. Many use stationary asset allocation models (e.g., mean-variance optimization) rather than more sophisticated, dynamic asset allocation models.

Question 54

What is TAMP?

Answer 54

turnkey asset management program (TAMP) is an outsourced investment management service for smaller wealth management firms that do not have the size or scale to maintain inhouse investment professionals

Question 55

What is an Advisory Fee?

Answer 55

The fee that Wealth management firms typically charge clients for financial advice and investment management services

Question 56

Study of 10,000 U.S. advisor portfolios found that the average investment product fee charged to clients via the investment vehicles is ___ %, with fees of ___ % and ___ % at the 5th and 95th percentiles, respectively.

Answer 56

0.54%

0.14% & 0.96%

Question 57

Chhabra defines wealth in three categories:

Answer 57

1. Tangible capital - This includes home, home mortgage, insurance, investment real estate, and art.
2. Financial capital - This includes investments and cash.
3. Human capital - This includes an individual’s skills, knowledge, and intangible capabilities that contribute to future earnings potential.

Question 58

Chhabra’s investor-centric wealth management framework recognizes three types of risks to which private wealth investors are exposed:

Answer 58

1. Personal risk - This is risk that could jeopardize a person’s basic standard of living (e.g., job loss or divorce).
2. Market risk - This risk comes from exposure to financial markets.
3. Aspirational risk - This is risk specific to one asset (e.g., a business or a small group of assets with potential for substantial loss)

Question 59

Investor’s optimal risk allocation should help them meet these 3 objectives:

Answer 59

1) Protect a basic standard of living (i.e., protect from personal risk).

2) Invest to maintain or improve a standard of living (i.e., assume market risk to earn a rate that exceeds inflation).

3) Increase wealth substantially or create impact (i.e., assume some idiosyncratic risk).

Question 60

What is mental accounting?

Answer 60

When the client compartmentalizez their assets into several categories and associated risks, rather than examining the risks as one portfolio

Question 61

What is sequence of returns risk and who is most prone to experiencing it?

Answer 61

Individual investors are subject to sequence of returns risk (i.e., risk associated with the order and timing of the return stream), where the path to achieve a return may be detrimental to a client’s financial situation, especially if the client is in the decumulation phase of the financial lifecycle, withdrawing funds

Illustration below:

Question 62

A study by the Vanguard Group tried to quantify the value of behavioral coaching in the value proposition. It estimates that a wealth advisor can add about ___% net returns (referred to as “___”) through non-investment activities (e.g., developing robust spending strategies, portfolio rebalancing, and tax planning); about half of which comes from behavioral coaching. This “alpha” can be ____ or ___ in that it is often gained in periods of extreme market performance, especially stressed periods.

Answer 62

3%

advisor alpha

lumpy or cyclical

Question 63

Why do some HNW clients lack the possibility to invest in alternatives?

Answer 63

Because the vehicles that are available to access alternatives (e.g., fund of funds and REITs), may result in higher internal expense ratios or performance that does not replicate institutionally-friendly vehicles