Regular FWR contributor and editorial board member Joe Reilly sits down with a figure in the US family office and wealth sector to discuss endowment models of investment, governance and alignment of interests.

Host of the Private Capital podcast and Family Wealth Report editorial board member – and regular contributor – Joseph Reilly talks to Casey Whalen, managing director, head, and CIO of Lazard Family Office Partners. Whalen, who is the former CIO of the New York Public Library, started her career at the Yale Investments Office.

Joe Reilly: Pioneering Portfolio Management by David Swensen has had a huge influence on family offices, but I'm curious about what you think people get wrong about what's come to be called the endowment model. 

Casey Whalen: The first thing I would say is that it is prescriptive and it is hard to talk about now that David is no longer here because you'd like to have him bounce [ideas] back and forth. 

I was talking to a couple of my former colleagues about it. There was never a “right asset allocation” that's specific for anyone. It was more about what is appropriate for you.  And this happens on the institutional side, too. 

I'm not sure whether it's specific to families, but they just want a prescriptive way of doing it [investing], and I always spend a lot of time initially with the families learning about them because everybody's goals are really different. Some families want all the money to go to the next generation, some want none of it, some want a mix of giving charitably, and some have family dynamics that make it more complicated. 

And then there is the behavioral [aspect] â€“ a lesson I learned on the institutional side. You must be able to create a portfolio that regardless of what the governance structure is â€“ which might be an individual person, or it might be a committee of people or trustees â€“ that they can actually stay invested in. 

I think the most damage that gets done in crisis events is when the markets are down, and you are a forced seller. Either because you need liquidity when you didn't think you did, or you can't behaviorally handle the drawdown because of the way the portfolio is acting. 

The other book David should have written was on governance. 

He did such a brilliant job in retrospect on governance, in terms of just the president of the school, the investment committee, which was mostly alumni, and the staff all being aligned 100 per cent. They disagreed on individual investments and would have a debate on that, but everybody was totally aligned on how to behave, what the asset allocation was, and what we were trying to achieve. 

So I think getting that alignment is really where things fall apart. I think you can see other institutions where governance breaks down – they might have had the best investment team there talent-wise, but it just breaks down because the governance wasn't working appropriately. 

So, in my opinion, that's the biggest thing. And with families, it's really behavioral because it is different. You're dealing with the principal. It's their money, it’s not an institution's money and at the end of the day, they can do whatever they want. There are no guideposts and guardrails that force them like a trustee to behave a certain way. 

Joe Reilly: I love this idea of alignment because with families you have so many stakeholders and advisors involved. Are there any ways that you learn to try to get everybody on the same page?  

Casey Whalen: It's such a good question.

I think communication and authenticity go a long way. And I think for us, because our approach is not cookie cutter, we might be using the same managers and recommendations, but every time we take in a portfolio, it's a completely new legacy portfolio. We very rarely take just cash in. If we do, that's great, but it's rare. So, I think it goes a long way to approach those initial discussions with respect, intellectual honesty, and authenticity because you don't know everything. And until you get the family to allow you to talk to the accountants and talk to their trust and estates attorneys and have everybody on the same page and talking together, do you really get a good idea of what has happened historically, and what they want to achieve going forward? Our legacy business, Truvvo Partners, has very large families. So, we're dealing with pretty complex portfolios and with a lot of people involved, and their initial first advisor could be an accountant or a trust and estates attorney when they created the wealth. 

And so you learn a lot from those people because some of them have been with the family from before they had the wealth creation event, and so you've got the full lifecycle.

We learned this from David too, with managers listening is an underrated skill. You must sit back and ask open-ended questions and you'll learn a lot. 

Then what we do is we take in that information, and we'll give a first level rush and then we'll say can you react to this? So, for example, we'll show a portfolio and we'll just show you the median or the mean return and volatility, but we'll show from the fifth to the 95th percentile. 

So, you show the tail and we say, okay, so for this portfolio, you have an expected return of X, but how do you feel in a crisis when correlations start to go up?  If you had a large hypothetical mark-to-market hit you will have some families that say, I literally want to throw up when you say that. 

And then you'll have other families that say, oh, I don't care. I'm a long-term investor. I'm a private equity investor, and that's fine. I don't really care. That's just like a mark. That doesn't mean anything. It's not actual permanent impairment of capital. That is telling just in terms of that iterative process to get to the right answer. 

And that's the behavioral piece. Because who walks into a room and says, this is my risk tolerance? Nobody says that. It's this process of communicating, creating things to get feedback on, and iterating on as you go along, and then, every year revisit, we talk about that on a regular basis when we're doing reporting and talking to the clients during quarterly updates, but once a year we'll review the asset allocation again and just make sure we're not missing anything or if there have been life events or grandkids and stuff like that, if things have changed.

Joe Reilly: Do you think asset allocation can be taught or is there some art to it?  

Casey Whalen: I hope it can be taught because I learned it, but there's definitely an art. 

Fixed income is a very easy example of this. You'll create an asset allocation. You create your model and say we're assuming fixed income is a safety net and that when the crisis event hits, there's going to be a flight to quality and that's going to do really well, and then people create their asset allocation model that way.

But then they fill the bucket up with things that don't behave that way. So, whether that's corporate credit or it's muni bonds, like in 2008, when people filled that bucket with muni bonds and thought they were insured, but the insurers themselves weren't great credits. Then all of a sudden you have an experience that is very unlike what you actually modeled in the portfolio. 

That happened to a lot of people with inflation hedges recently. Some people had things in those portfolios last year that didn't behave like inflation hedges. 

So, I think that's where some of those things break down. I think you learn that through taking risks and seeing what works. You can learn so much in crisis events about how you thought your portfolio was positioned and whether or not it played out [as you expected]. So, it is art and science for sure.