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Even the best-laid portfolio plans can be derailed by financial market caprices, but charity investors can give themselves a better chance of achieving stable, long term returns by avoiding a number of common mistakes. Here are the top five ways that an investment process often goes wrong.
1. FOCUSING ON THE SHORT TERM AT THE EXPENSE OF THE LONG TERM. When managing portfolios, investors need to consider both strategic and tactical asset allocation. Strategic asset allocation is the long term allocation to bonds, equities and other assets based on an investor’s risk parameters and goals. Tactical asset allocation is shorter term, aiming to adjust for temporary anomalies in markets, either to capitalise from mispricing, or protect portfolio returns against volatility.
Overall risk reward
Strategic asset allocation is similar to climate. Climate shapes the long term trend that sets the overall risk reward situation and changes slowly. For example, is the climate getting hotter (inflationary) or colder (deflationary) which in turn sets the tone for what works best overall in markets?
Tactical asset allocation is similar to the weather forecast. Do we need to take an umbrella when we leave the house tomorrow? Weather changes all the time, it accounts for most of the “noise” in markets and it is what drives 90% of the discussion you hear from market commentators.
It is easy to spend a lot of time talking about the weather (and many fund managers enjoy doing it) – politics in Europe, the latest manufacturing survey, the US/China trade negotiations, the latest employment numbers etc. . However, this can be a distraction from the more important business of establishing the investment climate and when it changes.
2. ASSUMING THE FUTURE WILL BE LIKE THE PAST. Often, investors will use the past behaviour of different asset classes to set their asset allocation today. For example, they may assume that because bonds have performed well at times of declining equity markets, they will continue to do so in the current volatility.
However, interest rate levels are very much lower today, economies and policies change and the past may be very different to the future. This has been particularly true in the wake of the global financial crisis as quantitative easing has distorted all markets.
Investment grade bonds
For example, historic annualised returns on a basket of investment grade bonds have been over 5% but bond yields used to be far higher. It is likely bond returns will be structurally lower going forward and those who expect returns to continue at 5% per year could be disappointed.
If you set your asset allocation and portfolio construction based on historic return and risk expectations, you might well find that your portfolios are not as diversified as expected In building the right asset allocation, you need to build in a sensible estimate of forward returns from various markets and the level of correlation between assets in different environments. While one cannot do this with accuracy, it is far better than assuming tomorrow will be exactly like yesterday.
3. BELIEVING ASSET ALLOCATION IS ALL THAT MATTERS. Does the following sound familiar? “One study suggests that more than 91.5% of a portfolio’s return is attributable to its mix of asset classes. In this study, individual stock selection and market timing accounted for less than 7% of a diversified portfolio’s return.”
Variation in quarterly returns
This is one of the most misquoted statements in the financial world. The original 1980s study by Brinson, Hood and Beehower found that asset allocation accounts for c.90%+ of the variation in a portfolio’s quarterly returns, not the level of returns themselves. This is an important distinction.
That is not to say that getting the asset allocation mix right isn’t important. A 2000 study by Ibbotson and Kaplan found, “40% of the return variation between funds is due to asset allocation”, but it also found that the balance was due to other factors, including asset class timing, style within asset classes, security selection, and fees.
In other words, investors cannot neglect the other elements in a portfolio believing that asset allocation is the only determinant of returns. Investors who do this often tend to populate their portfolios with passive funds, rather than actively selecting their holdings. Passive funds essentially follow a momentum strategy where they strategies buy new stocks when they are expensive and sell them when they are cheap.
One study found that from October 1989 to December 2017, the performance of stocks added to passive portfolios lagged those that were sold by an average of over 22% over the following year. This is the opposite of what famous investors such as Warren Buffet have advocated their whole careers - buying quality stocks at cheap prices.
Stock selection is also a key part of overall investment returns and risk control, one where expertise can add significant value. Some market participants and other investment houses have given up on this part of the process.
4. FALLING PREY TO BEHAVIOURAL BIASES. As humans we make poor investors because thousands of years of evolution mean that we are hard wired to certain behaviours. This is often seen as a problem only for hobbyist investors, who get caught up with fads, such as the technology bubble. There may be some truth in that, but all investors – including professional investors – are vulnerable to these issues no matter how many years of experience they have.
Commonplace behavioural biases
Over 100 behavioural biases have been uncovered, but there are a number that are commonplace: anchoring, for example, is when investors make decisions based on an arbitrary reference point. Gamblers’ fallacy is an assumption of reversion to the mean in circumstances and in series when there is no evidence that it exists.
At the same time, investors may be over-confident. This is particularly applicable to financial market professionals who may be very knowledgeable about a subject area and inclined to neglect information that is contrary to their view.
The phenomenon of “herding” will be familiar. Investors’ inclination to run with the herd, rather than strike out alone, is the key reason that investment “bubbles” form. It feels comfortable to act in the same way as other people, but the herd is not necessarily right, as many investors found out painfully when the technology bubble crashed in 2000.
Investors generally dislike losses (loss aversion) far more than they appreciate the equivalent gains. This can make them act irrationally, by taking much bigger risk to avoid a small loss, even when it would be far outweighed by the potential gain. Recency bias is a tendency to place greater weight on recent events, even when there is no reason for them to hold a higher weight.
What can we do about these behavioural biases? Being aware of this kind of problem is the first step in trying to avoid them. Quantitative models help us to look at markets objectively and ensure we are looking at the same data in the same way every day, month, quarter, year when we review portfolios and make tactical asset allocation decisions.
5. IGNORING PORTFOLIO CONSTRUCTION AND DIVERSIFICATION. It is easy to spend a lot of time focusing on selecting individual assets, without ever looking at how they come together in a portfolio. Portfolio construction is vitally important: markets rarely remain in equilibrium for long and always retain the potential to surprise us. Rising interest rates, geopolitical risk, environmental change and “black swan” events can all derail a portfolio in spite of the most meticulous planning.
Possibly being wrong
While it is clear portfolios should be biased towards what you think is most likely to happen, it is important to consider that we might be wrong. Portfolios include assets that would also do well if the unexpected happens or the initial analysis was incorrect. A common mistake is to think that financial markets will give you time to reposition: they often don’t. The common example given is the narrow door of a cinema on fire.
As part of their duty of care, charity trustees need to demonstrate effective monitoring of their investments and benchmarks are frequently used as part of this task. They face an array of different benchmarks to choose from. But what exactly is a benchmark and how are they best used?
Benchmarks are used for three main types of purpose. First, they can be used to set constraints on the types of asset and their proportions held in a portfolio. Second, they can be used to set targets to beat and third, they are often used to provide a comparator of similar strategies or client types.
There are three main types of benchmark: composite indices, target return (also known as absolute return) and peer group benchmarks.
A composite benchmark typically combines a series of market indices in similar proportions to the portfolio’s long term strategic asset allocation – assets held can be mapped/matched against long term liabilities to help determine the long term risk/return objectives.
The portfolio might include a mix of fixed interest, equity, alternative and real estate assets. For example, the UK government fixed interest exposure might be measured against the Markit iBoxx All Gilt index, the UK equity exposure against the MSCI UK Equity index, and so on. In turn these can be used to set constraints on the types of assets held - often minimum and maximum ranges are added within which a manager can act with discretion.
Comparison with subcomponents
This type of benchmark is also useful because it allows performance between the portfolio and the benchmark to be directly compared with its subcomponents. This in turn allows analysis of the differences at each level to be broken into asset allocation, stock picking and timing decisions. This can give important information to both the investment manager and client about the drivers of performance.
A target return benchmark measures portfolio progress against a fixed yardstick. For many charities the yardstick is preservation of the portfolio capital in real terms over the long term. A target return benchmark might therefore be an inflation measure (consumer price inflation - CPI, or retail price inflation - RPI) plus a margin to provide for income generation, costs and a buffer – in all this could be 3%-4% or more depending on risk profile and the inflation measure used.
It is important to remember that this is a longer term benchmark, most often used as a target to beat, and is less appropriate over short periods or in providing comparative data. Although not recommended due to distortions in index construction, composite benchmarks can also be used as targets to beat.
Peer group benchmarks were the first type of benchmark to be popularly used, and arose from the desire to compare portfolio performance with those portfolios invested by other managers. This usually involves looking at the performance of a group of charities or other funds which may or may not share similar objectives and risk profiles to your own. This can be a useful sense check to see how your portfolio is performing compared to others.
However, significantly, peer group benchmarks often do not consider the bespoke objectives of a charity and often group together portfolios with very different asset allocations and investment approaches. Thus focusing too much on relative peer group performance can distract from the ultimate objectives of a charity’s investments. As noted, their main use is as a comparative, but composite benchmarks can also be used for this purpose.
Evolution of benchmarks
It is helpful to note how benchmarks have evolved over the past 30 years, and how they can help meet the needs of the latest generations of investment managers and trustees. As already mentioned, peer group benchmarks were the first type of benchmark to become popular. The problem with the early peer group benchmarks was that only return was considered, irrespective of the risk taken to achieve those returns.
Thus trustees of portfolios underperforming the peer group may have been tempted to shift to riskier, better performing managers in order to achieve these higher returns. This realisation often encouraged fund managers to take on more risk in a race to the top of the table. The result of this was that in the inevitable downturn portfolios proved to be riskier than trustees were comfortable with.
Best practice led to the greater use of composite index benchmarks which looked like an ideal solution. However, trustees began to monitor achievement of their longterm objectives on increasingly short time frames, not over the full investment cycles which most active investment styles need.
Unsophisticated and impatient clients tended to buy managers at the peak of their outperformance and then sell out at their trough, thus damaging investment returns. In turn, investment managers learnt that it was safer in terms of mandate retention to tightly (“closet”) track the composite benchmark. Benchmark tracking error became a substitute for real risk.
With less real active management came less outperformance, opening the door for the rise in passive management. More importantly for this discussion, with the bursting of the dot.com bubble in 2000 and the financial crisis of 2008, trustees tended not to be that impressed when told how good performance had been – with, say, portfolios down by “only” 28%, when the benchmark fell by 30%.
This in turn has led to the greater use of the target return benchmark. However, as we go through the tenth year of the recovery after the financial crisis, there are a lot of investors wondering whether they made the right decision to track RPI + 3% during a period when markets have averaged RPI + 9%. In addition, these types of absolute returns can typically only be achieved in a downturn through the use of derivatives to protect from losses.
The cost of maintaining this type of insurance is usually prohibitively expensive, and so there are likely to be many portfolios that struggle to achieve these targets through the end of the cycle, whenever that may be.
Which benchmark is best?
The main problem with choosing benchmarks is that the moment anything is specifically measured, it tends to distort manager behaviour. This is as true of benchmarks to monitor hospital waiting times as it is of portfolio monitoring. In addition, investment managers and their clients often confuse the uses of different benchmarks and the time horizons over which they are most effective. Accordingly it is best to establish the types of benchmark, their use and the effective time horizon at the start of each mandate.
Each of the three types of investment benchmark discussed capture desirable characteristics that trustees would want to encourage and monitor in a portfolio. However, the focus on just one benchmark invariably leads to other desirable portfolio characteristics being neglected. As there is no single solution charities increasingly use a combination of all three types to reflect the uses to which each is best suited.
This approach helps provide a balance of desirable characteristics being monitored and encourages both the trustee and investment manager to pay close attention to all the characteristics. While this approach does not provide a hard and fast test of success and failure in the short term, it does help ensure that everyone is more focused on what really matters through the whole investment cycle.
How to use benchmarks
Charity trustees need to monitor the performance of their fund manager to make sure performance and risk are in line with expectations. However, expecting performance to match the benchmark at all times and in all situations is unrealistic. In order to beat the benchmark investment managers have to take positions away from the benchmark. Indeed, the question arises as to whether paying too much attention to the benchmark risks putting the cart before the horse.
Performance measurement is relatively easy to do but it is not a panacea. Moreover it can distract from the more detailed monitoring that investors frequently carry out when awarding mandates and then often ignore thereafter.
There is also a need to consider appropriate time horizons. For example, one might ask if measuring something over only three years is a misalignment of time horizons with a charity’s long term objectives. Given potential volatility, it is generally preferable that the longer the period a benchmark covers, the better. With any period of less than 10 years, it is hard to statistically distinguish skill from luck.
Some kinds of investments or strategies will work better than others in a bull or a bear market which means trustees should be looking at the whole investment cycle – peak to peak or trough to trough when assessing an investment manager’s performance. It is surprising how often there are requests to supply historic data for only five years by charity trustees or consultants looking to review investment managers.
A measured approach
The optimal solution is likely to depend on what a charity is looking to measure, as well as its sources of funding, its need for returns and its risk appetite, as well as its financial condition, its size and its scope of operations. Nevertheless, most charities with significant invested assets could probably benefit from a variety of benchmarks to ensure they are getting the most comprehensive view of the performance being delivered.
Ultimately, trustees have an obligation both to the charity’s beneficiaries and to the regulator to ensure that due consideration has been given to the ways in which the charity funds itself, including its investments. Benchmarks represent a useful tool in terms of providing some much needed transparency, but these should be used alongside monitoring of the ongoing investment process, portfolio construction, risk mitigation measures and the investment firm’s culture.