In the mid-1990s, Stuart Lucas read the writing on the wall, and it wasn't encouraging. He and his extended family--heirs to the Carnation Company fortune--faced a stark choice. They could either passively watch their collective wealth fade away--slowly but certainly--or they could strive for something better. With a bit of prodding from Stuart, the family opted for something better by taking more responsibility for managing their wealth.
Lucas is a fourth-generation heir of E.A. Stuart, a co-founder of Carnation, which traces its roots to the launch of the Pacific Coast Condensed Milk Company in 1899. The relatively modest venture grew into the Carnation Company, which was acquired in 1985 by Nestle for $3 billion in cash. The liquidity windfall was both a blessing and challenge, writes Lucas in a new book, Wealth: Grow It, Protect It, Spend It, and Share It (Wharton School Publishing). "Our family never anticipated the sale of Carnation," he confesses. "So, our family never adopted a coordinated approach to managing our wealth, should that eventuality arise."
Arise it did, to the tune of a $1 billion payout, divided up among a "large number" of family members. But the trustee managing the family's kitty delivered less than stellar results. In fact, the mediocre performance translated into declining distributions for the heirs, a financial state that looked doomed to continue without a strategic shakeup of one kind or another.
Between 1987 and 1994, the U.S. stock market advanced by a cumulative 133 percent, while the bond market rose by more than 92 percent, Lucas relates in the book. On that basis, a portfolio with a 60 percent weight in stocks and a 40 percent weight in bonds should have risen by 117 percent over that span. In fact, Lucas discovered that the family's portfolio had advanced only 31 percent. "Taking inflation into account, this meant that we hadn't really increased the value of our wealth at all," he writes.
The poor results inspired the family in the mid-1990s to take a more "proactive" role in managing the wealth, says Lucas, who serves as principal, trustee and investment advisor for the family office in Chicago.
"I persuaded my family that we needed to take a disciplined and coordinated approach to what I call 'strategic wealth management,'" he writes. He defines that particular approach to wealth building in broad terms, including defining the family's goals and values; setting investment objectives that span multiple generations; and otherwise employing a deft but decisive hand for keeping taxes to a minimum while maximizing return relative to the portfolio's risk tolerance and investment goals.
Running a family office is nothing new, of course. The precedent was set in 1882, when oil tycoon John D. Rockefeller created an institution for managing his family's wealth. But it's less than typical when a well-to-do family takes direct responsibility for the investment strategy. Rare, perhaps, but logical in the case of Lucas, a graduate of Harvard Business School who's a CFA and has earned NASD Series 7 and 66 licenses. Starting his career in the 1980s at Wellington Management as an investment analyst, Lucas now claims more than two decades of experience in wealth management and the investment profession. That includes a stretch as senior managing director of the ultra-high net worth group at Chicago-based Bank One. In addition to working in his family's office, he's recently set up Wealth Strategist Network (wealthstrategistnetwork.com), an educational organization.
His greatest professional and personal challenge is pursuing above-average returns on behalf of his extended family. Fortunately for Lucas and his fellow heirs, it's been a successful venture, he reports. As he details in the following interview, the investment success is largely driven by an unusually aggressive allocation to so-called alternative investments, which recently comprised about 50 percent of the portfolio.
Lucas has learned a thing or two over the years when it comes to wealth management. He also holds an exceptional perspective that springs from being both a consumer and provider of wealth management services.
You and your family have slowly but surely taken charge of your collective wealth, and severed the relationship with the former trustee along the way. What went wrong?
They were very well meaning folks, but they weren't as focused on the right things as they could have been. There were several areas where they could have been more effective. The first is that they could have focused more on milestones and measures, and maybe a little less on investment products. By that I mean improving their back office and systems for delivering better performance measurement--performance measurement that the client can understand.
As you move into alternative investments, the infrastructure that's required is much more complex because you have manual entries that are more prone to error. As a result, the challenge of measuring aggregate performance, and even the challenge of individual investments, becomes more complicated. It's difficult at the individual investment level, but it's also more difficult when you're trying to look at global results. At the end of the day, both the client and the advisor should really be focused on the question: How are the global results, and how are those results relative to expectations?
That said, we still work with a corporate trustee. I also work very closely with some other members of my family. We operate the business as a partnership in the true sense of the word. We've been doing that since about 1995, managing some parts of the portfolio as early as 1988.
Your advice sounds both reasonable and straightforward. Who could argue?
On the one hand, it's pretty straightforward, and it's easy to say. But implementing it is expensive and time consuming because there's often a very substantial software investment required. And when you're dealing with manual-entry issues, you might want to have some level of redundancy for double checking for eliminating human error. The greater complexity of the software and the double checks actually become quite expensive.
What system do you use to monitor the portfolio?
We've developed our own software, primarily using fairly complicated Excel spreadsheets. When it comes to alternative investments, that's a much taller order and many advisors aren't there yet. We measure stuff that most advisors don't, such as keeping long-term track records of cash flows. For instance, I have a chart that shows our rolling 10-year dollar returns, and I track how much cash has gone to spending, taxes, fees, and so on for each of the last 10 years.
Were there other challenges that convinced you to rethink who was calling the shots for your family's wealth?
Doing a better job of aligning the advisor's interest with the client was an issue, too. Related to that is defining the advisor's success by the client's success, and being held accountable for the clients' results. And that ties into my previous point of measuring results.
What's the ideal compensation structure in an advisor-client relationship?
I wish there was a perfect answer to that, but I think it depends on what the advisor's doing for the client.
If you look at the way advisors get paid, some are compensated by doing transactions--a broker, for example. That sets up a situation where advisor interests aren't well aligned with the client's. Other advisors get paid based on a percentage of assets, and that gets a little closer to the ideal. Even so, fee-based advisors still aren't being measured by their valued added except indirectly in that the assets will, hopefully, grow and so the fees in dollars paid increase.
For managing a traditional portfolio of stocks and bonds, what's your preference for compensation?
I think the two best ways are either as a percent of assets with--if you can measure it--some incentive compensation for creating alpha. The other way is a fee-only basis.
Generally, if the advisor defines success by the client's success--however he's compensated--he's accomplished the goal of aligning his interest with the client's. That's a slightly squishy answer, but compensation is a complex issue.
There are times in any business where the interest of the business and the interest of the client may come into conflict. Whether it's an investment business or an auto business or a widgets manufacturer. It's an issue for the investment business especially, where there is a fiduciary responsibility implied if not in fact. It's very important to put your client's interest first all the time. If you do that, you'll become trusted, and your business will grow.
What's an example of running afoul of the "putting the client first" rule?
There are the rare but occasional examples where advisers churn client assets, for instance. But that's not the challenging issue. We can all look at such cases and say that advisor went over the line.
I think the more difficult question is something like: "When is adding diversification to a client's portfolio good for the client vs increasing diversification to increase the advisor's fees?
Let's say a client has an actively managed total stock market investment portfolio, and it's highly diversified, and the fund charges a low fee of 50 basis points. As an alternative, an advisor might choose to own multiple funds targeting large cap growth, large value, mid cap, small cap, and so on. Each of those portfolios might charge in excess of 50 basis points.
There's an argument to be made that you can, for instance, overweight growth when it's attractive, or overweight small cap when it's attractive. But there are also costs associated with that. The question is whether or not it's in the client's interest to have a more complex portfolio vs sticking with a lower-cost portfolio.
Where do you come down on the question?
For many clients, a multi strategy portfolio adds complexity and cost and it probably is a tax drag--it's tax inefficient--and so it probably doesn't add value.
Was a multi-strategy policy in use when your family's portfolio was run by outsiders?
Yes, it was multi-strategy with only traditional investments. We had urged the advisor for some time to allow us to move into alternative investments. Initially, our hope was that the advisor could develop the expertise to do that. Eventually, we developed our own expertise because the advisor couldn't really figure out how to add that value.
One of the things that makes our family story a little bit different is that we were very fortunate that we had considerable investment experience. Two of us had spent all of our careers in the investment business. And we were able to build the expertise in-house that many individuals and families can't build or don't build.
In your book, you identify three strategies for managing wealth. The most-aggressive one, which you call an active alpha strategy, is used for managing your family's portfolio.
We use mostly active alpha, although we do index our core assets in a tax-managed index portfolio that allows us to harvest losses. That said, we use an asset allocation that is fairly uncommon in the private-client world but is increasingly common among top endowments. For example, we have no investment-grade fixed-income--at least no allocation to it. At the moment, we have a fair amount of cash, although that's a tactical play. Our alternative portfolio now is probably about 50 percent of the portfolio. Traditional equities make up the other half.
Private equity, venture capital, real estate, distressed securities of various types, emerging markets assets of various types, and then hedge funds, although we don't use hedge funds very much.
Really? Hedge funds are the popular choice these days when it comes to so-called alternative investments. Why aren't you jumping on the bandwagon?
It's very hard for us to figure out which hedge fund managers can add value net of fees, carried interest and taxes. Hedge funds in general aren't very tax efficient; they tend to turn over their portfolios pretty aggressively. Plus, they charge one and twenty [1 percent of assets plus 20 percent of any profits]. It's very difficult to pinpoint alpha in hedge funds, and it's easy to confuse alpha and beta when it comes to hedge funds.
One of the things we try to be cognitive of is not letting our aspirations get very far ahead of our capabilities. When your aspirations get ahead of your capabilities, that's a recipe for disaster. We would only build our hedge fund exposure when we think we have the ability to evaluate the managers reasonably effectively, and convince ourselves that we're right so that the performance results will generate alpha net of fees and taxes.
Speaking of alternative investments, you write in the book that real estate isn't necessarily an inflation hedge. More than a few people think otherwise, arguing that property is one of the better ways to protect and preserve wealth from the ravages of inflation.
In the investment world there are no absolutes. While it's important to understand and respect history, it's also important to recognize that history may not repeat itself in the way you expect. Making projections is always difficult because they're always prone to error. Anything I say, I say with that caveat.
Real estate valuations in many parts of the country and in many real estate asset classes are very high right now. Part of the reason they're high is because interest rates are quite low. If you get into an environment where inflation accelerates, it's also likely that interest rates will rise, at least in part because the Federal Reserve, seeing inflation accelerating, would increase short term rates to dampen inflation. Higher interest rates have a tendency to increase the discount rate of the future stream of income generated by a property--an income stream that defines the property's value. And so, you could find that real estate prices stay flat or even decline slightly in an environment of rising inflation and interest rates.
Does that possibility influence your thinking on how much to allocate to real estate these days?
Yes, it does. Generally, we've been lightening up on real estate, although we still invest selectively. Real estate is an awfully broad term, and there will be exceptions to the rule. We look for specific opportunities where we think that assets may be undervalued in a more difficult environment.
Do you buy property directly?
We almost exclusively work through third-party managers.
Overall, what are you trying to achieve with the active alpha strategy?
We're trying to maintain real, or inflation-adjusted per-capita wealth across generations. One of the things that's easy to loose sight of is that once you have wealth, it's often harder to maintain it than it is to create it in the first place. So, our goal is a very aggressive one to offset the demands on the wealth such as taxes, fees, and the fact that families tend to grow in numbers over time and family members spend some of the assets. When you add it all up, we need to generate a 12.5 percent to 13 percent rate of return per year in the portfolio over the long haul.
That's above the stock market's long-run average annualized return of about 10 percent. You're not likely to meet your target with a traditional stock/bond allocation, thus your relatively aggressive allocation to alternative investments.
That's absolutely correct.
In the book, you make the point that focusing on the values of the family, and the individuals is the first step for crafting a successful wealth management strategy. Why is that?
Without values as a cornerstone, all you've got is money. Money in and of itself may feel satisfying over the short run, but over the long run most people feel that they need something more than money to live a truly satisfying life. If we're fortunate enough to have some wealth, isn't it wonderful to appreciate it and use it effectively? That's where you get the tie-in to values. It also forces you to think long term, and think about the things that are really important to you and to harness what you're really good at. When you do those things, you build a different frame of reference and you live a more fulfilling life.