Getting the most from working with your investment manager
Covid-19 has created considerable challenges for charities’ finances given that many have seen unexpected pressure on their income at the same time as seeing rising demand for their support and resources. This left them needing cash just as stock markets fell, liquidity evaporated and dividends were sliced. Understandably, this has created some tensions in investment manager-trustee relationships as both sides have been forced to adapt to a new reality.
Investment management always works best when it is a two-way process. Investment managers need to understand what is expected, while those entrusting them with their wealth need to understand what is achievable. Whilst the last year cannot be rewritten, it can be a catalyst for better and more effective relationships.
With that in mind, here are some elements that I believe need to be in place for the investment manager and trustee relationship to work together smoothly: clear parameters, sustainability (ethical etc.) goals, early strategic planning, engaging with stakeholders and long term communication.
Clear parameters
Good investment management relies on understanding the rules of engagement. As such, some important guidelines need to be established up front. These will include, but aren’t limited to, the time horizon for investment, the risk tolerance, the requirements for income and the long term purpose of the capital. These parameters allow the investment manager to build a suitable portfolio to achieve these objectives and help the trustees set clear expectations by which the success of the strategy can be judged.
The process of setting guidelines will look at an appropriate risk budget or capacity. This is not only a judgement on the length of time the charity has to invest but will also look at its other sources of potential income and when it may need to draw down on the income or capital.
At this stage it is also worth having a clear discussion on the definition of risk, which can mean different things to different people. Investment managers are often likely to define risk in simple volatility terms. After all, for them volatility is easy to measure and readily understood. However, a truer definition of risk is perhaps the permanent loss of capital which can have some more challenging implications for trustees.
The right benchmarks
Part of this process will involve finding the right benchmarks. Note, this is not because investment managers should slavishly follow benchmarks; that’s a sure-fire way to increase short-termism and reduce diversification. However, benchmarks are a useful tool to judge and discuss performance, to understand how returns are derived and to compare returns against a similar peer group taking a similar level of risk.
Benchmarks can also be a means to judge the style of an investment manager, when they are likely to do well and badly, or if there are signs of style drift.
Specifically one would favour three different benchmark types: a long term target based on CPI plus a margin typically 1-4% depending on risk tolerance (primary long term focus); a comparative based on the tactical asset allocation from which one can derive contribution and attribution; and an appropriate risk based peer group comparator to focus on the opportunity cost.
Setting these parameters is important because the objectives, risk and ethical constraints will influence how one invests and the type of return investors can expect. At the extreme, it avoids the trustee being disappointed that the fund manager handed an income mandate hasn’t delivered technology-like returns. Comparing apples with apples can be difficult. If trustees don’t have the experience in-house, a consultant can be a valuable intermediary who can prevent misunderstandings.
Establishing cost parameters is also important. I would argue that value is more important than low cost, but cost decisions will nevertheless determine where one would take active risk. It could also influence how much of the portfolio an investment manager would run themselves rather than using third parties.
Sustainability goals
Sustainability (i.e. the ethical aspect) could easily be wrapped into the discussion above, but for many charities it has now become so important that it merits independent consideration. Increasingly, investors recognise how their capital can influence the world around them. This is particularly important for charities, which don’t want their reputation undone by a few misjudged investments.
These responsible investment goals are personal to every individual and charity – some may prioritise environmental goals, while for others, labour rights may be a greater focus. It is possible to be nuanced now about the exposure of investment portfolios as reporting and transparency improve. These goals need to be established before any investments are made.
It is important to establish upfront “non-negotiable” areas, but also areas where there may be some room for manoeuvre. For example, there may be areas that need to be excluded altogether and areas where investors are happy to take an “engagement” strategy – opening a dialogue with the company to try and improve its performance on specific issues.
Equally, it is important that sustainability goals and investment goals are not in conflict. As an example, the oil majors are among the highest dividend payers. Excluding them from a portfolio will leave a hole in an income portfolio. It is also worth noting that oil majors may be as much part of the solution as part of the problem.
Some are significant investors in renewables and shareholder pressure has been important in driving a change in strategic direction. As such, engagement rather than disinvestment may be a better option.
Early strategic planning
The investment parameters will be influenced by a charity’s strategic goals and objectives. As such, an investment manager needs an understanding of a charity’s long-term ambitions, its sources of funding and thus its need for cash and its resources (such as cash levels and reserves).
Charities also need to have considered a number of business or operational scenarios that might influence their need for cash. While very few saw the pandemic coming, it is always useful to know what might happen in the event of a charity’s key sources of revenue temporarily drying up – whether that is shops closing or events being cancelled.
This can help the investment manager build flexibility into the portfolio where necessary - such as diversifying the portfolio so there is sufficient liquidity or ensuring there are assets that can be sold in the case of a cash squeeze.
This strategic planning means that should there be a crisis, there is a contingency plan in place and the charity isn’t forced to compromise its charitable goals, or – in a worst case scenario – become insolvent. There should always be examination of a charity’s reserve policy, risk register and cash flow forecasts, incorporating this into investment planning.
Sadly, this has been a common problem during the pandemic. The demands on charities rose because more people needed their help, just as many of their sources of revenue dried up. Where this happened, there was a requirement to find solution, though in some cases it unavoidably involved selling assets. The trick here is to have enough diversification that it doesn’t become necessary to sell at risk assets that have experienced volatility, leaving them enough time to recover.
Engaging with stakeholders
It is worth considering the reporting needs and information required for the charity’s own stakeholders – including staff, donors and employees. The wider community is becoming more important for all charities. This process will help build an understanding of their concerns, which in turn will determine how the investment manager manages and reports on areas such as environmental, social and governance policy as well as performance of the portfolio.
This can also help establish if there are areas where additional support is needed, such as training for trustees. It will influence how the charity presents information in the annual reports, both the information given and the graphics that might be useful. How much detail will it want on the portfolio? Are certain metrics particularly important?
This could include, but isn’t limited to, areas such as the carbon footprint of the portfolio, environmental, social ad governance (ESG) scores or how the portfolio compares to the UN’s Sustainable Development Goals. Charities are always held to account by society and therefore good, effective communication transparency and suitable disclosure are a key part of bringing stakeholders on board.
Long term communication
The best investment management/trustee relationships are long term. Shifting investment managers is a time-consuming and expensive process, and it is far more effective and efficient to build understanding over time. This means making sure that there are clear reporting lines, clear communication, clear metrics for success and clear benchmarks. A breakdown in any of these facets can see problems arising.
In this pandemic period, for certain charities, there have been quite a high number of trustee changes, so good mandate documentation and strong induction training are necessary, so that new trustees properly understand the importance of requirements.
Time frame
Equally, it is important that the time frame is clear, understood and constantly reviewed. Trustees appoint a specific management group because they like the way it invests and, ultimately, believe it will deliver their objectives over the time frame. Although performance may be reported quarterly, investment managers need to be given the space to let their process work - ideally over an investment cycle.
There will be periods that don’t favour their style or market dynamics work against them. In such times the investment managers need to provide clear communication, demonstrate consistency of investment process and style to keep trustees informed.
Trustees also need to decide how they are going to communicate with their investment manager over the longer term. Do they want regular updates? An open dialogue and to whom? How should performance be reported to fit the expertise of the trustee group and when? It is also worth establishing when reviews will take place, along with strategy to plan for other outside factors and to mitigate such challenges. It is important to find a balance, avoiding a dearth of information or information overload – both are problematic.
Ultimately, the way to get the most from an investment manager is to set clear expectations and lines of communication at the outset and then establish a regular review process to ensure firstly, those expectations are being met and secondly, that there are no changes in the charity’s circumstances - to be certain that the investment objectives and timelines remain appropriate. This should clear a path for a long and effective relationship, where both sides understand their role.
This has been a testing time for both charities and investment managers. Charities have felt the strain of falling revenues and rising demand, while investment managers have had to contend with difficult and volatile markets. However, these challenges shouldn’t get in the way of an effective long term partnership where parameters are clear from the outset and communication is effective between both parties.