How are family offices using derivatives?

Implementing an asset allocation strategy that not only preserves wealth, but enhances and grows the family wealth pool is of the utmost importance to family offices. In an economic landscape with unprecedented low returns, this has never been such a challenge.

Whether the investment decision-makers within these highly secretive and prestigious institutions employ a passive or an active strategy, having the ability to execute investment decisions through a wide variety of financial instruments is vitally important.

With family offices becoming ever more sophisticated, there has been a shift in appetite towards using a different range of instruments – such as derivatives, or structured solutions – to meet the family’s specific investment objectives, as well as the growth and preservation mantra the family office stands for.

Vincent Garcier and Christophe Rault of Societe Generale explain how family offices are – and should be – using derivatives.

Family Office Intelligence: How has the derivatives market changed over the past five years? How have family offices reacted to these changes?

Vincent Garcier: First, it is striking to see that volumes on simple and plain vanilla derivatives traded with family offices – especially for financing and hedging purposes – have strongly increased in recent years. In the meantime, however, we have witnessed a change in the nature of the derivatives market.

Before 2008, the scope of derivatives, especially in the equity derivatives space, was extremely wide. A client could use derivatives for many different reasons: to buy or get an exposure to an asset class; to extract additional revenues from an equity position; to hedge a specific exposure; to lower the cost of financing; and so on. But the market has evolved over the past few years and, in a context of a low volatility and interest rates regime, the scope has narrowed in terms of the variety of products traded.

On top of the trend towards simpler instruments, which is continuing, this context of extremely low interest rates is particularly challenging for investment purposes, especially when designing capital-guaranteed structured solutions, and paves the way for unfunded investment solutions, such as swaps.

Family Office Intelligence: You mention increased activity among family offices, how have their attitudes changed towards derivative-based instruments?

Christophe Rault: In a continuous trend dating back to the Lehman crisis, there has been a global move towards more simplicity and increased transparency in the field of derivatives, and family offices have been no different to other investors in this way.

As a consequence, most derivatives used by family offices today are standard plain vanilla instruments and even some innovative structures, which may seem complex at first, are designed using only simple building blocks.

The top priorities for family offices are now reactivity, quality of execution and aggressiveness of pricing.

Family Office Intelligence: From your observations across the wider derivatives market, how are family offices using derivatives as stand-alone tools?

Vincent Garcier: Derivatives are very flexible tools that can be used in any given financial situation – investment, financing, hedging, yield-enhancement, and so on – in relation to a selected asset class, while respecting a set of constraints – be it legal, regulatory or taxation.

In our experience, as mentioned previously, an important part of our derivatives activity with family offices is related to financing operations, using derivatives-based structures to extract cash from strategic equity stakes.

Another popular use of these instruments is to design investment strategies in which derivatives offer a potential yield-enhancement and a protection against drawdown risks on top of a base investment, such as an equity portfolio.

Family Office Intelligence: How can family offices use derivatives to enhance returns in the current economic environment?

Vincent Garcier: Following the European Central Bank’s announcement that it will launch a quantitative easing programme, eurozone companies with export exposure to dollarised countries should benefit from a cheaper euro. Moreover, firms facing Swiss-based competition – in the luxury and health sectors, for example – should also take advantage of a stronger Swiss franc, as Swiss products will be more expensive abroad. The stock prices of Nestlé, Novartis and Richemont, for example, all suffered a major decline following the Swiss National Bank’s decision to abandon the minimum Swiss franc/euro exchange rate. Sectors such as luxury goods, wines and spirits, health and automotive should benefit from the new paradigm in the currency market. In this context, derivatives and structured solutions can be used to gain exposure to selected stocks or sectors that should benefit from the central banks’ decisions.

Family Office Intelligence: How are you specifically using derivatives with your family office clients?

Christophe Rault: Our team at Societe Generale is dedicated to family offices, and our philosophy is to work in close partnership with each of them through a long-term process of identifying and designing the best and most suitable solution, using instruments and techniques employed by corporate and institutional clients.

We think that derivatives should be seen and used as a ‘toolbox’ allowing us to build efficient solutions with completely tailored parameters.

Family Office Intelligence: What are the major benefits to family offices using derivatives?

Vincent Garcier: The key benefits of using derivatives are flexibility, simplicity and optimisation.  As over-the-counter instruments, derivatives offer great flexibility and can be designed to perfectly match any family office’s financial objectives. Besides, sophistication as such is not an objective any more and family offices favour simple, plain vanilla instruments to respond to potentially complex situations.

Last, but not least, derivatives have to do with optimisation. To give you an example, over-the-counter derivatives are used to replicate a listed instrument that a family office cannot easily trade due to its illiquidity. Derivatives, therefore, allow clients to improve pricing and facilitate execution, which are naturally key objectives for any investor, leading to optimised solutions compared to more traditional approaches.

Family Office Intelligence: What are the major concerns families have about these instruments?

Christophe Rault: More than real concerns over derivatives, most importantly, family offices want to understand perfectly how the structure works, what to expect in terms of potential returns and the risks implied by derivatives exposure.

Family Office Intelligence: Should family offices be using derivatives for speculative purposes?

Vincent Garcier: When used with proper caution by educated investors, derivatives are particularly powerful and flexible tools that allow bespoke exposure to a selected asset.

Moreover, hedging components can – and should – be added to these investment solutions in order to provide some protection for family offices.

Family Office Intelligence: How does the use of derivatives differ between single-family offices and multi-family offices?

Christophe Rault: Most of the time, single-family offices have their assets concentrated in one equity stake, which their wealth primarily stems from as industrial families. Therefore, their main use of derivatives is often to extract financing out of their strategic stake, hedge it or extract additional return from this strategic stake.

Multi-family offices, on the other hand, are more interested in the various investment opportunities offered by derivatives – structured notes, funds and innovative strategies, for example.