Charity investors have to take decisions all the time, whether on investment policy or in connection with their relationship with their investment managers. The articles below help you make these decisions.
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FROM THE EDITOR: This special focus on ethical or socially responsible investing (SRI) contains three articles – from Neville White of Ecclesiastical, John Ditchfield of Barchester Green and James Corah of CCLA, all involved in the activities of National Ethical Investment Week, which happens every October. This annual national focus on ethical investing is organised by the UK Sustainable Investment and Finance Association (UKSIF).
The three articles which follow here demonstrate the value of ethical investment to charity investors, provide a guide to being an ethical investor and, above all, move the concept into the more dynamic area of socially responsible investing where the role of charity investors in the relationship between them and the companies they invest in is much more proactive.
It will soon become apparent to any charity reading these articles that they need to get a good grip of this whole concept and their particular involvement in it. Yes, they have to have proper advice but they need to be satisfied that their advisers, i.e. third party fund managers, are operating according to their satisfaction. The last thing an SRI-minded charity wants is for it to be caught wrong-footed by bad publicity emanating from a company it has invested in, whether directly or via a pooled fund.
Attention is being focused on a quietly thriving part of the UK investment market. In the wake of widespread public disillusion with mainstream financial service providers, ethical and responsible investment products continue to show compelling growth. EIRIS, the ethical research services provider, puts assets under management in over 100 UK ethical or "green" retail products as exceeding £11bn.
For charities, ethical or responsible investment ought to be a default consideration. It supports wider mission objectives and can be favourably aligned with charitable objectives in a holistic way. The way a charity makes or invests its money ought to be as high on the importance list as how those funds are then distributed or spent.
More fundamental purpose
However, ethical or responsible investment can also serve a more fundamental purpose. There is compelling evidence that where integrated into the investment management approach, taking ESG (environmental, social and governance) considerations into account can contribute towards reducing risk and adding value.
This makes the role of informed charity investors all the more important. The faith and other voluntary and charity sectors represent a vital investor pool where performance over the long term, delivered responsibly, is of crucial importance and can help effect wider corporate change.
This focus on integrity, stewardship and responsible business practices that charity investors can bring to the table has never been more urgent. Whether it is excessive executive remuneration, the phone hacking scandal that engulfed the media, or the rigging of LIBOR and product mis-selling in financial services, the seemingly endless failure of business ethics and integrity – "doing the right thing" – is now seldom out of the news.
At the time of writing, the US healthcare giant Johnson & Johnson is reeling from a second massive fine to settle over 7,500 lawsuits, with a total malfeasance bill now standing at over $6bn. GlaxoSmithKline (GSK), among the UK’s largest businesses was handed down a record fine of $3bn as part of the largest healthcare fraud settlement in US history, whilst JP Morgan has agreed to settle a $5bn fine for mortgage mis-selling.
Almost constant scandal
The financial services sector has been engulfed in almost constant scandal recently, but at random, one might cite the record fine of $4.2bn handed down to HSBC for facilitating money laundering in Mexico, and a fine of $667m penalising Standard Chartered for illegal money transfers.
All of these recent corporate scandals have thrown governance risk and wider business ethics failure into sharp relief, proving that mismanagement, poor risk controls and excessive risk taking can, and do, destroy value for companies and investors alike.
It is now clear that the catastrophic explosion in the Gulf of Mexico over three years ago resulted from systemic operational failures on the part of BP and its partners. Liabilities have so far been provisioned at $42bn, more than the UK defence budget, and necessitating a "fire sale" of assets and the downsizing of BP as a business.
It is also clear that the destruction in value has been equally catastrophic for BP investors. This is particularly true of those institutional investors which held the company for its reliable source of dividend income – a dividend that was suspended in the wake of the disaster in June 2010, and not restored until 2011. Whilst the stock has recovered a little, it is still far below 2009 levels.
Poor risk management
What all these corporate events have in common is poor risk management. Because responsible investors analyse companies in a holistic way, considering the entirety of a company’s impacts and risks, including the ESG (environmental, social and governance) factors, a more rounded perspective is often forthcoming.
For instance, responsible investors may tend to avoid extractive industries, including oil, as they largely fail to meet environmental and human rights risk criteria. Instead they may decide to obtain value from accessing the supply chain into those industries.
A series of "events" at BP over many years - including pipeline leaks in Alaska, environmental penalties exceeding the norm, and the explosion at the Texas City refinery in 2005 - would have suggested that BP’s risk profile was unusually high. So by avoiding the stock, investors would have been shielded from catastrophic value destruction following the latest, engulfing, catastrophe.
The way one stock selects can also lead a charity investor to change a position if the ESG risk profile increases in terms of corporate "direction of travel". Until recently it would have been logical to hold the Norwegian champion Statoil as it historically focused on a single market – the Norwegian Continental Shelf – (North Sea oil and gas), had an excellent pollution and safety record, and was leading the way in developing carbon capture and storage technology.
With North Sea reserves in decline however, Statoil made a strategic decision to expand globally, into more challenging territories where human rights risk is material (Libya, Algeria, Angola), and also into unconventional Canadian oil sands which have a high climate change and water use impact.
One would also view "complex offshore" (the term used to define challenging wilderness exploration in the Arctic) as potentially very high risk. So it would be reasonable, listening to the senior management in Oslo, to conclude that the risk profile represented 25% of the Statoil portfolio and was growing. Therefore it wouldn't be surprising if this led to to the conclusion that Statoil was no longer a comfortable fit for ethical funds and disinvestment followed.
Statoil would easily contend for inclusion as a "best in class" stock, but a focus on long term risk and added value would have suggested that over time Statoil could encounter significant problems as a result of its quest to expand into socially and environmentally riskier assets. This has been borne out by a slight increase in the total recordable injury rate and a slight uptick in accidental oil spills from 374 in 2010 to 376 in 2011.
SRI adding value
The case for socially responsible investing helping to reduce volatility risk is complemented by the approach that stock selection based, in part, on ESG factors can positively add value. Let's say one seeks out companies which are not only providing goods and services that people want, but are doing so in a sustainable way.
For instance, the electronics giant Philips may be 120 years old, but it is currently transforming its business from a low growth-low margin consumer electronics business, into one centred on global leading positions in lighting, healthcare and high margin lifestyle consumer products.
Its portfolio is increasingly championing green innovation through its Eco Vision programme in which dedicated "green products" will soon represent nearly 50% of the portfolio by value (€11.2bn at 31 December 2012). This relentless focus on low energy, high performance products has been recognised by the market, and Philips' share price has recovered strongly.
This is where the choice of fund manager as investment partner can make a huge difference for charity trustees. The complexity of many issues may seem daunting for trustees, especially when charities exist to deliver their mission to society rather than improve the corporate world.
Trustees seeking to appoint fund managers should, I would argue, incorporate material ESG risk as part of their tender process. The degree of expertise, understanding and appetite the prospective fund manager has to engage with the companies in which they invest on your behalf should be seen as an important selection differentiator.
Posing straightforward questions
The choice of a fund manager is therefore a crucial one for any charity manager, but some fairly straightforward questions could be posed so that trustees can properly assess the likely interest a prospective manager has in integrating ESG factors into the investment process.
Trustees will want to ask a series of questions in order to understand the underlying ESG risk to their portfolio, and how this is to be managed, given the kind of issues managers are prepared to take action on is instructive. Hopefully, there will be ticks in all the boxes once the questions have been answered, indicating satisfaction with the answers given.
|Are managers voting?|
|How are they voting and how active do they appear to be?|
|Are trustees in receipt of a complete voting record and do managers publish their voting record in accordance with understood best practice?|
|Are they engaging with companies on governance risk and seeking change or improvement where there may be material issues?|
|Have they avoided investment on governance grounds and why?|
|Is the manager a signatory to the UN Principles of Responsible Investment and the UK Stewardship Code?|
|Are they willing to collaborate with other investors around significant issues?|
|What types of issue is the manager focused on and what have been the outcomes of any engagement process?|
|Is this published?|
|Do managers engage internationally?|
This list is not exhaustive, but I would contend that in a globalised, complex world which is increasingly focused on resource constraint, climate change and human rights, monitoring ESG risk should be part of trustee due diligence in overseeing their investment advisers and managers. Trustees should routinely question and probe on governance and "non-financial" risk and understand whether managers are active, competent and willing to act proactively in the best interests of their underlying investors on environmental, social and governance issues.
"…mismanagement, poor risk controls and excessive risk taking can, and do, destroy value for companies and investors alike."
"The case for socially responsible investing helping to reduce volatility risk is complemented by the approach that stock selection based, in part, on ESG factors can positively add value."
"…monitoring ESG risk should be part of trustee due diligence in overseeing their investment advisers and managers."
Charity trustees have a lot on their plate. They are ultimately responsible for the difficult decisions a charity makes about which vulnerable people or other cause should receive support. They need significant expertise and experience to make those decisions and usually do so on limited resources.
On top of this, charity trustees are increasingly being asked to make tough decisions about how a charity invests its pension, endowment or other funds. A survey found by the EIRIS Foundation found that 78% of the public think worse of a charity if it invests in funds contrary to its values.
This article seeks to address some of the concerns charities have expressed when it comes to deciding how to invest capital.
Easier said than done
For a busy trustee, aligning a charity’s assets with its charitable mission can seem like another item on an already full agenda. Worse still, it involves entering the highly complex and fraught world of investment. From property to private equity, impact investing to infrastructure, common investments to commodities – investment unfortunately remains an industry that is short on good factual information and long on jargon and strong opinions.
So what are the real facts that trustees and charity managers need to consider if they want to invest in a more responsible or ethical way, or a way that more clearly aligns with their charitable mission?
Statutory obligation to consult
Firstly, trustees do need to consider professional advice from a suitably qualified individual. The Trustee Act of 2000 introduced a clear statutory obligation for all UK trustees (with the exception of trustees of very small organisations) that they must consult with an investment professional before making an investment.
All too often this is the moment where the discussion around ethical, responsible or sustainable investment first flounders – as surprisingly few financial advisers are active in the area. The UK Ethical Investment Association, a membership body for ethical investment advisers, only has around 100 members from the 23,000 independent financial advisers registered in the UK.
Secondly, the law requires charity trustees to be able to justify the adoption of an ethical or responsible investment policy based on one or all of three criteria laid out in the CC14 guidance from the Charity Commission. These three alternative justifications are:
• If a particular investment conflicts with the aims of the charity.
• If the charity might lose supporters or beneficiaries if it does not invest in this way.
• If there is no significant financial detriment.
Setting a clear direction
Thirdly, trustees need to be clear about exactly what the charity is trying to achieve by investing its funds. For example, the objective may be to maximise income, ensure a stable future income or to further the charity’s mission.
Whatever the objective, it should not be an impediment to adopting a responsible or ethical approach. With around 90 "green" and ethical funds on the market there are ways to meet practically all objectives, including the delivery of strong returns or outperformance.
Both profits and principles
The reason most often advanced by trustees for not instigating an ethical investment policy is a perception that it will have a negative impact on returns. However, this reasoning is long outdated and challenged by numerous academic studies and anecdotal evidence.
For example, there is a large environmental campaign group which excludes all large oil and gas companies from their investments. Despite having these screens in place their investments still consistently outperform the benchmark index.
The old stereotype that equates ethical investment with underperformance is also challenged by Steve Kenny, head of retail sales for the Kames Ethical Equity Fund, which is currently ranked first quartile over one, three and five years. He explains: “There is a long standing myth held by many investors that those wanting to invest ethically do so at the cost of performance. Our ethical investing funds have long proven this to be a myth…ethical investors can have their cake and eat it.”
The Kames Equity Fund has returned over 33% in the last year, compared to 26% for a relevant benchmark (IMA UK All Companies). Those interested in emerging markets could turn to a fund such as the First State Asia Pacific Sustainability fund, which has delivered 30% returns over 3 years.
Indeed, there is a strong argument, especially for those investors with a more long term horizon, that it is more risky not to consider sustainability issues when making an investment. That is because companies which don’t manage areas like labour rights, community relations or environmental impact are more likely to be affected by fines, consumer backlashes or regulatory changes which can affect their value.
For example, a recent report by the "Carbon Tracker" initiative found that 80% of the fossil fuel reserves which investors currently treat as assets cannot be burnt if we are to keep global warming within 2°C, meaning the oil and gas companies holding those reserves are likely to be significantly overvalued.
Different types of ethical policy
If charity trustees do decide to adopt a more ethical or responsible investment approach then they also need to be aware of the three different approaches that they can take: "negative screening", "positive screening" and "stakeholder activism". Or in simple terms: excluding, supporting or engaging.
Negative screening means avoiding investment in specific companies or sectors. Positive screening means proactively investing in a theme, company or sector deemed to reflect a charity’s mission.Stakeholder activism refers to a charity using its influence as a shareholder – including exercising its voting rights – to try and improve a company’s performance in a way that reflects its values.
There are many sub-divisions within these general areas. For example the positive screening approach could include investments in a themed fund (such as a renewable energy fund) or could take the form of investments in social enterprises which explicitly produce positive social or environmental outcomes.
Barrow Cadbury Trust, a foundation which supports vulnerable people, recently demonstrated the latter approach by investing £200,000 in Bristol Together, a company which has promised both a decent return and the creation of full-time jobs for ex-offenders and homeless people.
Charities do amazing work to help create a better society, and there is no reason why the £60 billion of assets 1owned by the UK’s registered charities cannot be invested to do likewise.
In the complex world of investment, with the myriad of options and products on offer, trustees may find that using the values and principles of their charity as a guide actually helps make investment decisions a lot more straightforward than they otherwise might be. It could take at least one item off their plate.
"It is wrong for my charity to exclude investment in certain sectors." 'It is not legal to do so." "It will cost me performance." "We just fund the charity, it is up to the 'mission team' to deliver our aims." "It's a church thing, not for us." These are just some of the myths about ethical investment held in some corners of the charity sector. We have all heard these statements many times, particularly by sceptics. However, as John Ditchfield helpfully reminds us in the previous article, if ethical investment is done properly all of these myths are, well, just myths.
Nevertheless, picking up where John left off, even amongst "the converted" there remains one prevalent myth. That ethical investment is only about setting appropriate ethical exclusions.
Ethical exclusions just the beginning
Do not get me wrong, ethical exclusions are vitally important. They are about identifying the things that contrast most obviously with your charity’s aims, the things that would call into question the reputation of your charity. But they are just the beginning, the foundations of an ethical investment policy, and this is also reflected within the new Charity Commission Guidance.
This says that charity investors should also look to be outward facing with their policies. Indeed the Charity Commission states that “investment managers should vote and engage with company management as a matter of course”.
One way that many charities do this is through engaging with company managements, otherwise known as stewardship of companies. This is done either directly, or more often, through the selection of investment managers which have advanced practices in this area.
Motivations behind conducting employment
The motivations behind conducting engagement take on two forms.
First, many fund managers conduct engagement as part of their approach to integrating environmental, social and governance factors into their investment process. As Neville White has helpfully explained in his article earlier, integrating these factors into an investment process is critical to ensuring, as much as possible, the long term durability of investment returns.
The best integrated policies include both point of purchase considerations and also engagement with companies which are held within the portfolio. This engagement is essential as it guides and shapes companies to help them make appropriate decisions about how to allocate their resources to develop sustained long term returns for shareholders.
This isn't ethical investment, although it comes naturally to investors from that background. It is just "wise investment". Everyone managing money, no matter what their perspective on ethical investment, should be doing it.
The second form of engagement is purely an extension of an ethical investment policy. It is about taking your charity's core mission into the boardrooms of the companies you invest in; using the ownership rights that come with your investments as one lever to try and achieve the change which your charity exists to make. This is a lesser used, but very powerful, approach and can easily be done in several ways including those listed in the following table.
|Proxy voting||In the vast majority of cases shareholdings permit investors to vote on the resolutions put to companies' Annual General Meeting. This gives the shareholders the ability to vote on the election of directors, the executive remuneration package, and any proposals placed by other shareholders by way of example. The majority of fund managers will vote their shares. However, leading managers consult their clients to ensure that votes adequately represent their views.||Proxy voting is a relatively time efficient method of engagement. The ability to place votes means that it is easy to engage with many companies irrespective of geographical location.|
|Letter based engagement||Investors can write to companies asking for them to provide information or implement improvements in a particular area of activity.||Letters are an efficient way of writing to a large number of companies. It is an effective way of asking many companies to improve their practices.|
|Meetings||Investors can ask to meet with companies to discuss areas that cause them issues. This practice is normally reserved for larger investors but charities are able to collaborate with other likeminded charities or mandate their fund manager to engage on their behalf.||Face to face meetings are an effective way of generating trust between the investor and company. It allows the development of a mutual understanding on a topic and, over time, progress to be made.|
|Annual General Meeting attendance||Investors are permitted to attend company AGMs and ask questions of the board of directors on any issue.||This is a high profile strategy due to the public nature of the meeting. The tactic is usually the preserve of NGOs and smaller investors who do not benefit from the ability to conduct other methods of engagement. Institutional investors rarely ask questions at AGMs, when they do so it is normally a method of escalating an ongoing engagement.|
Each of these techniques are commonly used by ethical investors and there are good examples of where real change has resulted.
Collective proxy voting initiative
In regards to proxy voting the Church Investors Group, the membership body for 44 church investors predominantly based in the UK and Ireland, have devised a collective initiative that allows them to lodge their votes in a manner that reflects their values. The main focus of this initiative is executive remuneration where they typically do not support two thirds of UK executive remuneration reports due to their belief that executive pay has, typically, become excessive.
The initiative also includes sustainability and diversity factors alongside promoting high standards of corporate governance. By working together these charities have been able to aggregate the impact of their votes as they seek to change corporate practice across the UK market.
Ethical investors have also effectively used letter-based engagement as a method of achieving impact on the scale required to raise standards across the whole UK market. Academics at the University of Edinburgh studied the effectiveness of a collaborative letter-based engagement project conducted by investment managers.
This encouraged companies in the FTSE 350 who had scored poorly on the FTSE ESG Risk Ratings (an independent objective method of assessing companies’ approach to environmental, social and governance factors) to improve their practices. The academics found statistically significant evidence that the engagement had made a difference and raised standards.
More intensive engagement techniques
Ethical investors tend to adopt more intensive engagement techniques when they identify issues of concern at individual companies or in individual sectors. Driving this type of change requires significant time and resources to put into in-depth meetings with companies.
A good example within the UK relates to an international coalition of charities, churches and advocacy groups which worked together to help the two FTSE 100 constituent hotel providers, Whitbread and InterContinental Hotels Group, put in place effective procedures and training programmes to mitigate the risk of their facilities, unbeknown and not condoned by them, being used for the purposes of child sex trafficking.
Following the engagement, both groups instigated training for their staff and franchise holders and consulted expert organisations in setting policy amongst other initiatives. These investors had driven a change in corporate practice.
Finally, investors have effectively used questions at AGMs as an effective method to build upon ongoing engagement that, for whatever reason, requires further momentum and escalation. The public nature of the AGM makes this a high profile tactic but it works best when used in conjunction with other techniques such as those above.
So, ethical investment is not only about ethical restrictions. It can include engagement with the companies a charity invests in as a further lever to deliver that charity's mission. It is a powerful tool in delivering change. However, there remain three misconceptions about engagement itself.
Misconceptions about engagement
The first is that engagement is an excuse for fund managers to invest in companies that charities and their beneficiaries do not want them to. It is beyond doubt that this has happened in some sectors of the market in the past. To avoid this, your fund manager should be able to tell you what it is they are hoping to achieve by any engagement and details of progress made. Leading managers will go one step further and, after time, divest from a company if they are not willing to listen to engagement.
The second misconception is that engagement is a form of campaigning and is confrontational to the company. When done well this is not the case. By having more than a token shareholding in the company, investors are able to show clear alignment. Both organisations want the company to do well and develop profits. They just differ on one area of practice. This alignment allows for the development of trust and partnership and is one of the reasons why investor engagement is such a productive tool.
The final misconception is that only large charity investors can do engagement. This is not true. In practice the majority of charities are reliant upon their fund manager to conduct such engagement. Many do this and it is one of many factors charities can consider when appointing fund managers.
Help from external organisations
Several external organisations also exist to help charities come together to develop practice and encourage collaborative engagement. Church investors have long benefited from the ability to work together through the Church Investors Group and the new Charities Responsible Investment Network offers the same for charities of all backgrounds.
Despite all of the myths of ethical investment it is a powerful tool that can not only protect the reputation of the charity but, when done well, further deliver its charitable purpose through engagement. I recommend you to look at how this may work for your charity.
"…many fund managers conduct engagement as part of their approach to integrating environmental, social and governance factors into their investment process."
"Ethical investors tend to adopt more intensive engagement techniques when they identify issues of concern at individual companies or in individual sectors."
"…your fund manager should be able to tell you what it is they are hoping to achieve by any engagement and details of progress made."
How responsive should charity investment strategies be?
FROM THE EDITOR: The aim of this feature is to focus the minds of charity trustees and charity finance directors in particular on how they should plan for the possibility or respond to the actuality of investment markets turning severely downwards after long, sustained rises and to what extent a long term charity investment strategy should have flexibility built into it to deal with turbulence and more than short-lived movements in the other direction.
Just how long should the nerve of a charity investment committee be expected to hold when a market goes in the wrong direction? When is the point that the investment adviser should accept that the charity could have difficulties in sticking with the strategy, e.g. because of a variety of financial pressures coming together? How should investment advisers and charities be working together to address the problem of unexpected sustained market downturns?
We have six contributors who answer these questions in their own individual ways below. They are: Charles MacKinnon of Thurleigh Investment Management, Kate Rogers of Cazenove Capital Management, Adrian Taylor of Smith & Williamson Investment Management , Mike Goddings of Ecclesiastical Investment Management, Tom Rutherford of JP Morgan Private Bank, Christian Flackett of investment firm GAN, and Patrick Ghali of hedge fund advisory company Sussex Partners.
Please scroll down to see each article.
Establish what you are trying to do
CHARLES MACKINNON of THURLEIGH INVESTMENT MANAGERS comments: All charities owe their foundation and genesis to a perceived shortfall in society’s provision for some general need. This need may be very broad, for example provision of care for the elderly, or very specific, such as providing medical care and support for very premature babies.
It is the nature of this charitable aim that generates tension for the trustees in their choice of investments. A well known example is that cancer charities may not wish to invest in tobacco companies, on the basis that the products of these companies are, in part, the cause of the ills which the charity is seeking to cure. This tension has to be balanced with the need of the trustees to provide the best possible outcome for the largest number of possible beneficiaries.
It may be that by rigorously eliminating tobacco and its associated products and services from your portfolio, you so savagely reduce the investment outcomes that the charity is unable to perform its basic charitable aims.
Leaving aside the conflicts of how to invest, there is also the conflict of whether to invest at all, or to invest now. This is where the relationship between the head of the charity, the head of its investment committee and its investment manager is of paramount importance. For most charities there is an almost infinite call on their resources, but there is only a finite amount of return that can be extracted.
As part of the budget process a charity needs to include a detailed projection of likely, best and worst case outcomes from its investment portfolio. This set of possible outcomes should then be strictly attended to when making commitments for future spending, and if this is done, then the whole process is much more resilient to the vagaries of the market.
Recent market movements have highlighted the need for a responsive strategy, with two boom and bust cycles since 2000, and most importantly very low interest rates on cash and short dated bonds over the recent five years. If a charity had held its assets in cash over this period it would have suffered a significant diminution in its ability to perform its charitable aims.
This is where the relationship between the charity and the mandate it gives its investment manager is of paramount importance. The charity has to first establish what it is trying to do in financial terms as opposed to in social terms, and then it must relay this to the manager who may say that the aims are not achievable in the market.
For example, it is not possible to provide a guaranteed return of 10% on your money with no risk to capital in the current market environment. So, if you as the head of a charity want a 10% annualised return, you are going to have to accept some risk to capital, and some variability in the timings of that return.
CHARLES MACKINNON of THURLEIGH says: So what to do today? We have record low interest rates in the UK and the USA, and equity markets have recently once again scaled new highs in nominal terms. If you, as a cautious charity have been sitting in cash for the last five years you have suffered a massive opportunity cost, but should you start to commit capital to the market today? If you, as a well endowed and mature charity have been fully invested and have enjoyed the significant returns from recent equity market rallies, should you be stepping away?
The answer is the same for both: work out what your obligations are, and then work out what you would like to do but will only do if there is funding, and establish a time frame for these aspirations. What you should not do is take a view on the future direction of interest rates or equity market returns, and building your budget around those views.
Invest long term and change infrequently
KATE ROGERS of CAZENOVE CAPITAL MANAGEMENT comments: Beware of the phrases "things are different this time" and "new paradigm". We go in cycles, what comes around goes around. History has a habit of repeating itself. Charities as long term participants in society should not be phased by the endless oscillations. A bit like the experienced grandfather figure, we've seen it all before.
Charity investments exist to help charities further their mission. As reserves, in case of fluctuations in income; or as foundation or endowment assets, generating income to spend on their charitable aims.
Charity investment strategies should be designed for each individual circumstance and should be framed by the ability to tolerate volatility in capital value and the charity’s investment time horizon. Reserve assets tend to have a lower tolerance for moving values and a shorter time frame when compared with foundations and endowments. These are the real grandfathers of the charity investment world.
It is these assets which represent the bulk of charity investments. These charities have very long term time horizons, often with an aspiration for perpetuity, or eternal life. Investment strategies can take a very long term view, giving charities a distinct advantage over other investors such as private individuals or pension funds, who have shorter time frames or defined liabilities. As the adage says, everything comes to he who waits.
So am I proposing a lack of action in charity portfolios? A long term buy and hold strategy? No. I am suggesting that investment strategy should be set with the long term in mind, but I would encourage regular review. Strategy, in investment terms, can be defined as the long term asset mix that best meets the needs of your charity as expressed in your written investment policy.
This should not be changed regularly, unless there is fundamental change either in your own circumstances or in investment markets.Which brings us back to the original question: how responsive should charity investment strategies actually be?
I would argue that the definition of a "fundamental change in investment markets" is at the heart of answering this question. Where the investment world changes fundamentally, charity investment strategies should be rewritten and asset mix changes may be significant. A fundamental change is one that is likely to be permanent, or at least secular not cyclical, i.e. multi-decade not multi-year. One that is factual, not subjective or based on expectations.
An example in recent history might be the broadening of asset classes available to charities over the last two decades. As the number of pooled funds in alternative asset classes - property, commodities, private equity, absolute return - increases, so does the choice for smaller charity investors and the ability for diversification within investment portfolios.
Charity investment strategies should be very responsive to fundamental changes, which should provoke a reappraisal of long term strategy. In addition, a charity investment portfolio should be able to be responsive to shorter term changes in markets, and should have the flexibility to reflect the views of the investment manager and the trustees.
These more subjective views are inherently more uncertain, and the extent of their expression within portfolios needs to be controlled so that a wrong move doesn’t derail the entire long term strategy.
In a period of down equity markets it can be difficult for trustees to stick with a long term investment strategy, but it is also notoriously difficult to time markets. Just as trustees may wish to reduce their exposure to equities in down markets, they will wish to increase exposure in better times. Missing the best 10 days in global equity markets (MSCI World) from 2002 to 2012 was the difference between a return of 69% fully invested, and a return of -5%. It is time in the market, not timing the market that generates returns.
KATE ROGERS of CAZENOVE says: I would advocate charities adopting a strategy and staying the course. The governance of this can be improved by determining worst case scenarios, allowing trustees some comfort that, within a certain range, a period of negative equity returns is a "normal" market event.
So use your position as a long term investor to your advantage. Decide on an investment strategy that best meets your aims, and stick with it. Review regularly, change infrequently and only based on fundamentals. Respond to shorter term market movements to take advantage of opportunities, but do it in a risk controlled manner in order to avoid jeopardising your long term strategy. And don’t panic. Short termism can be a significant detractor to long term value. Unless, of course, it really is "different this time"
Putting investment decisions into a structure
ADRIAN TAYLOR of SMITH & WILLIAMSON INVESTMENT MANAGEMENT comments: Finding a universal investment strategy which is suitable for every charity, and which is unaffected by possible market volatility, is extremely difficult. Each investment decision is unique to every charity and should be considered using three key steps.
First is to set the investment objectives. For this, the trustees should address the charity’s aims as defined in the governing document or scheme, and be prepared to regularly review those objectives.
Second step is to consider risk. Defined in several ways, such as fluctuations in capital and income values, the level of risk to achieve the required return should be agreed by the trustees. They also need to consider the investment timescale which may help to iron out any short term market volatility.
The Charity Commission encourages trustees through its investment guidance notes (CC14) to give significant attention to these issues. These guidelines may help trustees to address a question frequently heard: “After a strong performance in 2013, and given an uncertain global background, should we be seeking protection against a sudden downturn?”
This leads to the third step of assessing the investment outlook. With the future often uncertain, investment managers emphasise the importance of advising charities on the most appropriate solution to match their objectives and approach to risk taking.
In today’s market there is an array of assets available to meet most charity investors’ needs. These include bonds and alternative assets, offering different market characteristics from equities, which can help to deliver smoother, although potentially more modest, investment returns.
There are also synthetic structured products and other derivative instruments, which aim to provide an element of downside protection. However, these may incorporate a capped upside, meaning gains could be restricted if assets rise beyond set limits.
While not possible to control the exact investment outcome it is, of course, feasible to build a portfolio of assets to accommodate a range of probable outcomes and which is in line with your risk/reward requirements. This strategy may need to take into account other factors such as the unwillingness to accept a drop in income, or a fall in capital value, as both may be necessitated in the short term. Alternatively a five year investment strategy will mean that you hold fewer concerns about any short term market volatility.
It is important to maintain flexibility as even a long term strategic investment approach should include the ability to take advantage of short term anomalies or cope with sudden significant setbacks.
The benefit of this approach can be shown through the example of BP, the UK-quoted stock. Until the Gulf of Mexico disaster in April 2010 it represented 8% of the FTSE All Share Index providing 15% of the index’s total income. It was a popular investment with an attractive and consistent income and growth record.
The disaster saw a dramatic fall in share price and a temporary suspension of its dividend which impacted many investors’ income streams.
Those with a diverse and flexible investment strategy may have chosen to sell and invest the proceeds in alternative income stocks and then repurchase BP when confidence returned. Others would have looked to buy on weakness.
Both approaches can have merit and depend upon the trustees’ attitude to risk and reward. It also shows the importance of ensuring that a proportion of the charity’s assets are sufficiently liquid and not tied in for the long term, so that it can respond to unforeseen situations.
This also highlights that while a good stock selection in a portfolio is helpful, a full understanding of the objectives and a risk assessment are necessary to achieve appropriate results.
ADRIAN TAYLOR of SMITH & WILLIAMSON says: This is where a strong relationship, including regular communication, with your investment manager is important, particularly at times of market volatility. They understand the investment outlook and can assess how the probabilities associated with a range of portfolio structures can meet your needs. This should provide for an appropriate investment solution in an uncertain and challenging investment environment.
The trustees must also clearly understand their charity’s investment objectives and ensure there is a strong correlation with the charity’s investment strategy. They have to review regularly their investment strategy and ensure that it remains appropriate, particularly in times of in changing markets.
In reality there is no perfect solution. While predicting the future is difficult an efficient investment strategy should combine a careful analysis of your objectives and requirements over risk and return, while drawing on the skills of an investment adviser.
Getting the investment management agreement right
MIKE GODDINGS of ECCLESIATICAL INVESTMENT MANAGEMENT comments: The noughties were a fraught decade for charities from an investment perspective, with an unusually high number of severe market downturns. Consequently, many new investors will have learned to their cost that timing and duration of investment are as fundamentally important as asset allocation in determining returns.
Not only was it a decade of unpleasant surprises for capital values, for existing investors, it was also one in which it was a struggle to recover lost income resulting from Gordon Brown’s clunking fist punching a 20% hole in equity dividend distributions by removing advanced corporation tax credit.
And since then, heightened volatility has become the norm.
In determining whether and how charities should respond to changes in the market, it is worth highlighting the differences between private investors and charity trustees. Private investors are not bound by charity law; they are able to make decisions in isolation rather than by committee, and as a result can invariably react more quickly.
The degree to which charity trustees can exercise any kind of responsiveness to market conditions will also depend on the type of arrangement they have with their investment manager. Very few managers now facilitate advisory agreements under which trustees can seek advice, and then choose whether or not to act on it. However, this really is the only way that rapid decisions – rightly or wrongly – can be made in the face of changing circumstances.
Most investment managers will operate under a discretionary mandate which enables them to manage the money as they see fit. Risk will often be controlled by asset allocation, with the manager free to move within predefined bands. It is therefore vitally important to ensure that this agreement defines the level of risk or volatility that will be acceptable, and review this in the light of any change in the charity’s circumstance rather than as a reaction to adverse market conditions.
Those charities investing in funds with no encompassing management agreement need to look closely at how they have performed in bear markets. Whilst past performance is not guaranteed to be repeated, it is none the less an indication of how the manager reacts to changing circumstances. For that reason, it is also important to establish whether the same manager is still in place.
The importance of getting it right from the outset – rather than panicking at the first sign of trouble – cannot be overstated. The investment management agreement is there for this purpose, and reputable fund management firms use independent sources to calculate volatility or other measures of risk.
Contrary to popular belief, even the best investment managers cannot forecast the severity and duration of a market downturn, and certainly cannot predict it precisely in advance, so any decision to move out of higher risk assets may be like shutting the stable door after the horse has bolted. Although this may be appropriate if the charity’s circumstances have changed to the extent that further capital losses cannot be tolerated, a simple knee-jerk reaction to continuing bad news may have negative implications for future beneficiaries.
Realising or seeking to cap an unrealised loss by sheltering in a temporary safe haven can pose problems. Ultimately, a decision has to be made to continue the journey towards future capital and income growth when the weather forecast predicts it is safer to venture out into riskier waters. However, the point at which markets revert to positive returns is equally difficult to predict, as is the rate at which they accelerate. The probability of bailing out of a falling market and re-entering it on the rebound at a lower point than when it was exited is inevitably quite low, and can often mean the value of the portfolio will have been eroded for no reason.
MIKE GODDINGS of ECCLESIASTICAL says: Although a market fall of 20% sounds scary, selling 100 shares for 80p simply because they were originally worth £1, and then having to buy them back for £1.10 after the initial rally means you end up with only 73 shares worth £80 instead of 100 shares worth £110. And if each share was producing a dividend of 10p per share, not only have you forgone that income for the time spent sheltering from the storm, your new income will be £7.30 instead of £10 – a 27% reduction when your obligations to future beneficiaries are likely to have increased, therefore further widening the gap.
This is clearly an overly simplistic example, as it takes no account of any gains or losses made whilst sheltering in lower risk assets, nor does it include the costs of sale and purchase, all of which have the potential to improve or worsen the outcome. It does however highlight the advantages of being able to take a longer term view by looking across the valley to the hills beyond, and reinforces the importance of getting the groundwork right.
Focus on risk rather than timing
TOM RUTHERFORD of JP MORGAN PRIVATE BANK comments: There are many good reasons to invest in equities over the long term. As we pass the five year anniversary of the nadir of the crisis – at least in stock market terms – so many will rejoice about the upwards trajectory and a lately improved economic outlook. However, such are the memories of the financial crisis of 2008-9 that others will reflect on the cyclical fragility of markets and hope they are better positioned to cope with any future pronounced downturn.
Of course the charity investment market is a diverse realm so it is perhaps unrealistic to suppose that one size will fit all when it comes to gauging the right level of sensitivity that should be shown. The sector displays huge disparities of wealth and income, seeking to satisfy an equally bewildering array of objectives over very different timeframes.
A lucky few will cite an investment time horizon of many hundreds of years and will bias their endowment asset allocations in favour of riskier assets claiming not to care for the bumps and dips along the road. This institutional thinking borrows from the norms of pension fund investment management, in particular, and provides an academic rationale for onboarding few defensive shifts on a short term tactical basis.
However, this approach was seriously tested during the depths of the recent crisis in the spectre of financial Armageddon and trustees need to be sure about their fiduciary obligations to adopt this line.
It is beyond the infrastructure and capabilities of most charities, indeed of many advisers, to time markets precisely and so it is unrealistic to place too much expectation on this approach.
Portfolio construction experts will cite statistics suggesting that over three quarters of long term returns are driven by strategic asset allocation – i.e. the mix of cash, equities, bonds, commodities, hedge funds, property and private equity in any portfolio. The less liquid of these are the preserve of larger portfolios and are not suitable for all charities.
Yet protecting the value of assets during prolonged market downturns does give a powerful compounding effect to long run returns, so some degree of tactical awareness is warranted. Adept advisers will weight portfolios towards or away from riskier assets as the environment suggests. Here a discretionary investment framework offers greater utility understanding that constraints and limits to activism will apply.
Speaking to the usage of hedge funds and structured products specifically, many trustees are hesitant towards such strategies which can serve to reduce overall portfolio volatility and protect capital value during times of market stress. These absolute return orientated mechanisms are usually expensive by comparison to traditional “buy and hold” approaches and often beyond the comprehension of the lay members on the board.
Understandably the less financially savvy may veto such mechanisms. Yet this may import downside risk through reliance on a narrower set of assets or, worse, a misplaced sense of protection through investing in line with observed peer group practice.
Cue a well meaning yet circular discussion as to which risks are appropriate for charities. Simply put there is no clear answer and behind all assets lurk potential dangers: developed equity markets contend with all time highs and uncertain sentiment, while emerging markets reflect the inevitable worries of an uncertain geo-political backdrop; bonds carry duration risk in case rates suddenly increase; and hedge funds and structured products designed to protect value during times of weakness carry illiquidity and issuer default risk. All the while inflation washes away the real value of cash balances.
The point here is not to scaremonger charities away from investing altogether, rather to identify that different asset types assume different forms of risk. With this in mind there is utility in trying to calibrate acceptable levels of risk, and not just expected levels of return, when determining the optimal asset allocation over the long run.
TOM RUTHERFORD of JP MORGAN says: So, if a charity is most concerned about realising its assets at times of stress, then illiquidity and investment default risk may be of greater concern to them. Whereas those more anxious for the nominal loss of capital value – whether or not realised – might have greater concerns for the extent and nature of their equity exposure, potentially increasing exposures to hedge funds or structured products. Those with longer term horizons might not share such worries as explored above.
Those with less income dependency to fund operations may seek to build up cash levels to deploy capital opportunistically at better entry levels as much as a pre-emptive defensive tactic. And so forth.
Both charities and advisers have a duty to think about the likely and possible scenarios and to build their investment portfolios accordingly. Here trustees can help their advisers by clearly stating their priorities so those advisers can think around these specific risks allocations within the portfolio. Within a plural sector different styles and strategies will work better with different charities. Thinking through scenarios works well for all.
Flexibility to absorb short term market strategies
CHRISTIAN FLACKETT of investment firm GAM comments: Charity finance directors and trustees face a complex task in ensuring that they can effectively fund current activities and campaigns, while safeguarding assets for future plans and projects. The sustainability of charities’ business strategies depends on their ability to protect and grow assets throughout the market cycle. This requires taking a long term view, and knowing when to stick with your original strategy despite short term volatility.
Charities must plan for the possibility that the market could experience a downturn after a period of impressive growth following the global financial crisis. Investment strategies must therefore have the flexibility to absorb short term market swings.
Most charities do opt for a diversified portfolio to help protect against market moves - even if equities are at the heart of the strategy. If the portfolio is truly diversified to include non-correlated asset classes, one can reasonably expect a meaningful cushioning of any blow should equity markets suffer a large and/or sustained period of turbulence.
Now that permanently endowed charities can adopt a total return approach without seeking Charity Commission authorisation, trustees are able to include less yield-focussed, non-correlated asset classes such as credit long/short or macro-focused funds.
However, equities remain the most effective way to monetise human ingenuity and deserve to be at the heart of any well-diversified portfolio. 50% in the equities of the portfolio (the growth book) and 50% in non-correlated assets (the capital preservation book) is a useful starting point. This does however vary from case to case – each charity is different and has requirements unique to it. Even a 100% equity portfolio may potentially be appropriate for a charity with a very long time-horizon and no near term funding requirements.
When markets dip past experience tells us that trustees should hold their nerve and ride out the volatility as equity markets tend to regain their losses, even if it takes some time. Capitulating in a trough will only lock in the loss. Non-correlated assets should, however, provide some relief in the meantime.
One of the first things would-be investment managers are taught is to establish the risk profile of their client. As part of this process, the investment manager should ascertain what level of volatility the charity trustees can stomach and make absolutely clear what can happen in a realistic “worst case scenario”, for example a 50% correction in equity markets.
Take for example a charity with a 100% equity portfolio. Then imagine a period of severe equity turbulence which the trustees react to by selling out when the endowment has lost 50%. You can only conclude that the investment strategy was not suitable in the first place for this charity and a more diversified portfolio should have been agreed.
Investment managers must work closely with charity trustees to explain the process of investing. One method which is very effective is regular educational seminars. These should not be events where asset managers sell their services, but rather where they educate trustees on what they can reasonably expect from an investment portfolio.
CHRISTIAN FLACKETT of GAM says: Charities have a right to timely and open communication from their appointed investment managers on the opportunities, dangers and implications of the current investment environment. Portfolio review meetings should ideally be held every six months (and at least annually) to ensure that investment strategy and asset allocation remain suitable. There should be at least two portfolio manager contacts at an investment provider who are well known to the trustees and are available for contact at any point.
Both parties must be cognisant that circumstances can change (for example if a charity which previously required income now needs a more aggressive growth strategy) and it may not be appropriate to wait until the next scheduled review meeting to instigate a change. Some flexibility should always be retained.
One of the key messages is that a carefully constructed diversified portfolio is likely to give you a higher unit of return per unit of risk (a higher Sharpe ratio) and should dampen those peak to trough falls considerably. A diversified portfolio is therefore likely to provide the most sustainable, least volatile returns over the long term.
Charity trustees and finance directors could face considerable financial pressure should portfolios continue to underperform over a sustained period of time, but in most instances they should stay the course. Regular interaction with investment managers is key to understanding recent performance and planning to ensure a strategy remains sustainable. Trustees should avoid making rash investment decisions and have the patience to wait for returns to recover after volatile market episodes.
Hedging out large swings for charity investors
PATRICK GHALI of hedge fund advisory company SUSSEX PARTNERS comments: With the current bull market in equities in its fifth year, many charity boards and investment managers are asking themselves a) should we be more aggressive in our investments to avoid criticism for underperformance, b) should we reduce our exposure to risk, as the bond markets seem to be nudging the bear and every pundit states that stocks cannot continue their feverish pace?
These questions are facing every charity, endowment and pension fund. We have arrived at the proverbial “rock and a hard place”. While many equity markets hit new highs, the China slowdown is worsening, emerging markets currencies are in crisis, and the situation in the Ukraine is suggesting the commencement of a 21st century cold war, with tariffs and embargoes to follow, resulting in economic losses all around. What to do?
In general, but especially in times like these, we feel that there are some basic investment truths that any charity investor should try to remember. They include the benefits of diversification, targeting risk adjusted returns net of all fees, and establishing a balanced risk/return profile to a conservative degree in order to compound positive returns over long periods of time.
But more important than the above is the individual you chose to pursue these aims – the identification of a proven, top performing portfolio manager. Then, let him do his job, in good times and bad.
The fundamental issue is that the majority of paid professional investment managers underperform their respective indices. A recent study in the US compared the returns from 1997 to 2012 of a passive index composed of 60% equities and 40% bonds to 5,000 actively managed portfolios doing the same. 82.9% of the actively managed portfolios underperformed.
Furthermore, one of the objectives that the remaining 17.1% of actively managed portfolios may not be able to solve is market volatility. For this solution you need to turn to those who can effectively hedge out large swings. This means the consideration of alternative asset managers, including hedge funds.
However, hedge funds themselves are not a panacea. Selection is key, and understanding the idiosyncratic risks associated with different strategies, conducting ongoing investment and operational due diligence, and creating a sufficiently diversified portfolio to hedge against the aforementioned volatility all require deep capital pools, significant infrastructure and very specialised skills.
For these reasons, funds of hedge funds rather than single manager hedge funds may be more appropriate for most investors. Additionally, a recent research paper by JP Morgan has looked at funds of hedge funds as a bond replacement, and has found that they may be well suited as such in the current market environment, generating returns that are comparable to BBB bonds with lower levels of volatility. As the rule applies in conventional markets, identification of an outstanding hedge fund of funds portfolio manager can yield extraordinary results.
Above you have the net returns for two fund of funds managers, one regional and one global, superimposed on top of the returns for the underlying markets. The returns speak for themselves. In the end, what one feels these types of managers should deliver year in and year out are "sleep at night” portfolios.
The key to the above graph is the word “net". There is much complaining in the press about a second layer of fees paid to a fund of funds manager, which I feel holds little merit. A fund of funds manager is nothing but a portfolio manager who prefers to sit in his office instead of yours and reap the benefits from his performance.
Furthermore, they hold a few other benefits not visible on the surface – access to closed managers, the ability to negotiate better fee and liquidity terms, and importantly the fact that you as an investor can terminate them much quicker than you could restructure an internal team (typically on monthly or quarterly notice).
PATRICK GHALI of SUSSEX PARTNERS says: Time and time again, one has asked charity trustees and charity chief executives/finance directors to honestly compare the net performance, which means after all relevant internal and external direct and indirect costs, of their existing portfolios against an outstanding (i.e. top performing) fund of funds manager in the same sector. The outstanding fund of funds manager comes out on top.
Many charity investors are most concerned with having confidence in their cash flows. The aim therefore is to compound positive returns on a superior risk adjusted basis with a high degree of certainty.
With the "easy money” having already been made, and given the current level of uncertainty, the difficulty of trying to time markets, the devastating effect of substantial draw downs, and on the other hand the potential risk of missing out on continued upside, considering a more flexible approach may be more prudent, than sticking to a traditional portfolio which may be ill suited to sudden changes.
Investment relationships at a time of change
FROM THE EDITOR: This special comment feature looks at what should constitute a good working relationship between a charity and its investment manager, particularly at a time of change. It is in fact an ongoing feature and there will be additional comments published over time. While the contributors may mention the same themes, e.g. good communication and trust, it is refreshing to see how they all discuss them differently, with each article quickly assuming its own separate look and making its own individual impact. Indeed, the articles cover a range of issues, so it is well worth reading all of them.
Knowing the right questions to ask and when
MIKE GODDINGS of ECCLESIASTICAL INVESTMENT MANAGEMENT comments: In an industry which is perceived as being dominated by egos and lacking humility in some quarters, handling the investment manager relationship can be an intimidating task for the chair of an investment committee. Less so if the chair in question has a strong investment background, but other problems can arise if the “lay members” of the committee get left behind, with the chair driving the debate.
Therein lies the risk that human nature being what it is, rather than disagree with a forceful client, an investment manager can allow the discussion to venture into technical territory, unfamiliar to the majority of those present. Whilst the outcomes may be entirely satisfactory, there is always the risk that the obvious questions remain unasked, and when the chair moves on to pastures new, remaining trustees may well have cause to question a legacy arrangement that was a product of individual rather than collective responsibility.
Easier said than done, admittedly, but the moral of the tale is don’t be afraid to ask! The strength of an investment management relationship, or lack of it, can be exposed by knowing the right questions to ask, and knowing the right time to ask them.
Regardless of knowledge and experience, the main thrust of trustees’ interest should be in seeing the capital and income components increase within the agreed risk parameters. And by using the simple expedient of asking what, when, how and why, they should get the answers they need. That's the theory. In reality, it can depend on the type of relationship you have with your investment manager.
Charities with larger investments will invariably have a discretionary, or in a small number of cases, an advisory, or non-discretionary investment management agreement. In the case of a discretionary portfolio, the investment manager will invest the assets in the best way he or she thinks will best meet the charity’s pre-agreed objectives.
A non-discretionary portfolio will be managed on the basis that the trustees decide what they want to invest in, and will periodically seek the investment manager’s advice, which they may or may not choose to take. Clearly any charity with the latter arrangement must feel confident in the ability of its trustees to make these decisions, which is why delegating the responsibility to an investment manager via a discretionary arrangement is a lot more prevalent.
However, this does not absolve the trustees from the ultimate responsibility for ensuring they comply with the requirements of the Trustee Act 2000 – namely to consider whether the individual or collective investments are suitable; are sufficiently diversified, and to regularly review the portfolio to reassure themselves it continues to meet the charity’s objectives.
MIKE GODDINGS of ECCLESIASTICAL continues: Clearly the opportunities to do these things are limited. Investments are by their very nature long term, and short term judgment calls on overall performance, benchmark achievement and therefore whether they meet the charity’s objectives can only be undertaken every few years.
Equally, the voluntary nature of trusteeship means that meetings are infrequent, and therefore it is essential to establish a protocol for dealing with each aspect of these responsibilities. Detailed valuations will normally be produced each quarter providing the opportunity to consider individual stock holdings, review the dividends paid and any changes in asset and market allocation.
The same report for the same period in the previous year, and the prior quarter in the current year should highlight the major changes. Hopefully there shouldn’t be any surprises, but if the majority of the income is now coming from one stock or asset class or if there is a significant variation, now is the time to ask why. Similarly, if after years of investing in recognisable blue chip companies, the portfolio looks to be investing in unfamiliar names or places or Funds, check them out on Google, and then ask why.
Longer term review against objectives should be well prepared in advance, and the investment manager should be aware that this is on the agenda in advance of the meeting. Surprisingly few investment committees ask for a copy of the investment manager’s annual presentation before he or she comes to visit, with the result that their key concerns remain unaddressed.
Requesting a copy in good time before the meeting will not only help trustees frame their questions, it also provides the opportunity for the manager to amend it where necessary and visually illustrate key points in a more convincing way than a simple verbal response which could lead to misunderstanding.
MARK GODDINGS of ECCLESIASTICAL says: A perennial question is what constitutes an appropriate time period for an overall review? The oft given response is around five years, with maybe an interim review at three years, but there is no right answer.
Sometimes it will fall naturally away from the agreed benchmark or investment objective, e.g. to generate an annualised real return against inflation of x% on a rolling five year basis. In which case, this can be assessed annually following the initial five year period, or in the case of an investment in a specific fund, it can be assessed annually.
Some investment managers seek to cover themselves by agreeing to less quantifiable or open ended benchmarks which may not even coincide with the elapsed time period of investment, and thus it is more difficult to establish whether they are doing well or badly.
In such cases it might pay trustees to ask them to break down their performance (or provide an attribution analysis) against the market indices in which they invest, and also against other charity portfolios using reference to independent performance measurement companies such as the WM Company.
Any reluctance to do this should start warning bells ringing. One way of partly resolving the issue of review frequency is to adopt a multi-manager approach, where the portfolio is split between two or more companies who are each tasked with achieving the same overall objective. This can also help trustees with their requirement to ensure adequate diversification where each manager addresses the objective by investing in different markets/sectors and with different exposures to market capitalisation.
This approach not only provides a regular opportunity to make relative comparisons, it also provides greater flexibility in being able to take action sooner rather than later.
Being absolutely clear with the investment manager
HELEN HARVIE of law firm BARLOW ROBBINS comments: The landscape for charity investments has changed substantially for charity trustees, in particular with the relaxing of the duty to invest for maximum return, and with the new concepts of programme related and mixed motive investments. Now more than ever the relationship between a charity and its investment manager is crucial to ensure that both parties understand the requirements for dealing with financial investments in order to develop a fruitful long term partnership.
The best working relationships develop when charities have got the basics right. When creating an investment portfolio, trustees must ensure that they have the power to invest, that they are able to delegate authority to a manager and that the proper processes and documentation have been put in place. Express powers may be contained in the charity’s constitution or there are the statutory powers in the Trustee Act 2000.
Trustees owe a duty of care to ensure that the “standard investment criteria” are met and that they consider the suitability of each particular investment, and the need for diversification in the portfolio. The duty of care is higher for trustees with specialist skills and this may affect those charities with portfolios large enough to warrant having an investment or finance committee.
From the outset, when delegating to a manager, it is vital to have a written investment policy in place, as well as a written agreement which states that the manager must act in accordance with that policy. The terms of the policy and the appointment of the manager must be reviewed regularly.
Good practice suggests that the performance of the investments should be reviewed at least annually and the choice of manager at least every two to three years. As long as the trustees follow these procedures, they will not be personally liable for the decisions of the manager, even if there is a substantial loss in the value of the investments.
The choice of manager is important and affects the relationship that develops. Trustees should look for a regulated firm or individual with a sound reputation, experience in the charity sector and the ability to deal with charity requirements and restrictions. In particular the candidate should demonstrate the ability to deal with smaller portfolios and take a longer term view than most commercial investors.
The trustees are likely to want a tailored portfolio and service, even where the portfolio value is low and they should compare costs, service levels and approaches to investments before making their choice. Spending time choosing the right manager will help reduce the risk of problems later.
HELEN HARVIE of BARLOW ROBBINS continues: A clear investment policy is vital to ensure that the chosen manager fully understands and carries out the wishes of the charity and avoids mistakes which could undermine the working relationship.
The policy should be as full as possible and at the very least should cover: financial objectives; attitude to risk; asset classes and alternative assets; pooled funds or segregated assets (or both); any restrictions on investment powers; any ethical investment requirements; any permanent endowment, restricted funds and reserves; income or capital growth or both; cash needs and timing; target return or total return approach; reporting requirements and performance measurement and benchmarking.
With these basic building blocks in place at the outset, a good manager should be able to develop a trusted adviser role, offering proactive advice on investments and regularly feeding back to the trustees with clear explanations for any changes. The manager needs detailed information and instructions from the trustees, ideally reporting to one key individual.
To perform effectively the manager should gain a clear understanding of the overall objectives of the charity, the time frame for particular investments, the need for income and any particular deadlines during the year, as well as the overall appetite for risk. A manager who is interested in the activities of the charity and listens to the trustees is more likely to be valued.
Regular meetings should form part of the relationship. Face to face meetings avoid misunderstandings and can be helpful in speeding up decision making during times of change. Variations to the original instructions should be confirmed in writing. As well as developing a good working relationship with the main contact, contact with the charity’s accountant is also important to ensure that the charity has the information it requires for its annual accounts.
HELEN HARVIE of BARLOW ROBBINS says: Agreement on the way the performance of the manager is to be evaluated is also of great importance. There are likely to be income/capital growth targets in the investment policy. The manager should be able to show the performance of individual funds against an industry average. Benchmarks such as the WM Charity Fund Monitor or the FTSE All Share Index may be used but only if the comparison is representative. Comparisons with other charity funds operating in the same sector may be more useful.
The best relationship between a charity and its manager is one where both parties are open and clear about their expectations, and have good channels of communication in place to deal unexpected circumstances. The trustees have a duty to set clear objectives and ensure that performance is constantly reviewed and fairly evaluated.
However, it is important to strike a balance. A better working relationship is created if the manager does not constantly feel that he or she is likely to be replaced at the end of the year. Even so, the trustees must intervene if there is poor performance, a change of circumstances or an economic downturn.
A positive working relationship between a charity and its investment manager is essential. From the charity’s point of view, it will help protect the personal position of the individual trustees and ensure that the charity meets its investment targets. A long term relationship with an investment manager is built on trust and performance. If both parties enter into the arrangement prepared to invest time in developing a mutual understanding, a fruitful working relationship should follow.
Greater transparency is the way forward
GINA MILLER of investment firm SCM PRIVATE comments: In today’s tough economic conditions, charities are having to work harder than ever to generate returns from their investments to fund their vital work and the role of the investment manager can now make a critical difference between success and failure.
However, charities are also, rightly, questioning the value they gain from the fees they pay for professional advice. In flat markets, investment managers need to prove the return they generate and this is particularly the case given that many commentators argue we are entering a "new normal" where returns from investments will be at a lower level than they have been in the past.
A recent paper written by three highly eminent London Business School professors (Dimson, Marsh and Staunton) suggests the real returns that can be expected from equities could be just 3% to 3.5% a year for the medium term.
As charity investors analyse their portfolios and re-examine their asset allocation policies and risk management strategies, they will require that investment managers not only understand their changing needs and objectives, but also have the commitment and resources to deliver appropriate solutions.
To succeed in this demanding environment, investment managers will need to re-examine their organisation and structure, and focus on a proactive communication approach with clients; as well as promote greater transparency in all their activities, dealings, technology/systems, and processes to promote investor trust in an industry where it is ebbing away.
This means giving greater transparency on fees and charges, something that is an important issue for businesses, consumers and the Government. Indeed, recent consumer research SCM conducted in January 2013 found that 62% of people would invest more if there was full transparency. While this may be true for individual savers, it is no different for institutions such as charities.
For charities looking for a good working relationship with their investment managers, understanding the fees they are paying for investment advice, offset against the returns generated is clearly critical. Since 2008, fluctuating stock market returns and a wave of financial scandals have led to investors questioning performance more than they have ever done before and this gives charities an opportunity to forge a new relationship with their fund managers and to ensure the returns generated meet their ongoing funding needs.
GINA MILLER of SCM PRIVATE continues: The four key elements that charities seek as investors are:
• Trust that the manager's investment team has the resources and expertise to implement the investment strategy and that their relationship manager will be proactive in responding to a client’s needs.
• Reassurance about the manager's resources, strength and commitment, as well as the firm's ability to remain viable during volatile times.
• Confidence in both the robust nature of a manager's investment process and the manager's openness and honesty in dealing with difficult issues or negative performance.
• Aligned interests to prevent the investment manager having completely different incentives and motivations to the charity and its trustees, known as goal incongruence.
In relation to the last point, the fund manager may be rewarded by his employer for how many charity clients he manages rather than the service, performance and risk attached to investing. In addition, unless the fund manager has a realistic attitude towards and respect of risk, he will, in effect, often gamble rather than invest the charitable funds. The ultimate test is if the manager is co-investing in the same strategy, on the same terms and fees as for the charity. If not he is bound to have a different outlook and a different emphasis on building and protecting the investment.
GINA MILLER of SCM PRIVATE says: To address the issue of 100% transparency on all investment charges it is recommended that charities ask their investment manager the following 10 questions:
1. Are ALL fees and costs associated with my investment being made available to the trustees in an easy to understand number?
2. Does this include an estimate of the full cost of buying and selling within the funds?
3. If the investment is in a fund of fund structure, do the fees include the full costs of the underlying funds or ETFs?
4. Is a FULL breakdown of all the holdings within the fund or portfolio available?
5. How liquid are the investments? If circumstances change, how long would it take to get cash back into the charity’s bank account?
6. Does the fund or portfolio manager invest in the same portfolio, on exactly the same terms and fee?
7. Has the investment process and associated literature been designed so they are simple and understandable?
8. Is the fund manager paying higher than execution-only dealing rates in order to gain "free research" from brokers?
9. Does my fund manager or adviser own shares in the fund manager or platform in which I am invested?
10. How easy is it to talk to the fund or portfolio manager?
In the current climate, the work done by charities is in greater demand than ever with charity finance under unprecedented strain. In the face of this challenge, charities need to be far more proactive in managing and monitoring the performance of their investments. It is time they forged a new relationship with the investment management industry which puts them firmly in charge, and full transparency on costs and fees is the way to achieve this.
Managing the change from passive to active management
PAUL MITCHELL of NEWTON INVESTMENT MANAGEMENT comments: The times they are a-changin', as Bob Dylan sang. They certainly are for charity investors. As we continue to experience a prolonged period of low growth and low interest rates, we face the prospect of lower returns with higher volatility becoming a “new normal”. Against this challenging backdrop, charities should question their investment managers over the ability of their investment portfolios to match their return requirements.
While state intervention keeps sovereign debt yields and interest rates at historic lows and tightens financial sector regulation, markets will continue to be beset by volatility and distortions, and the question of how to achieve return objectives will require innovative thinking, broad perspective and investment skill.
There's a battle outside
And it is ragin'
It'll soon shake your windows
And rattle your walls
For the times they are a-changin'
So how could charities best manage their investments during such times? The actions of policy makers may continue to drive near term rallies in financial asset prices, but are likely to amount to little more than short term sticking plasters.
Amid sharp fluctuations in market prices, investors have placed more emphasis upon capital preservation: investing is no longer guided by the sole motivation of increasing your returns. Active management is key in terms of helping charity investors avoid the impact of market declines. For those passive investors who are shackled to market indices, there are fewer options to protect against capital losses in times of market turmoil.
Many managers believe that the alignment of portfolio composition to equity and bond indices restricts their ability both to guard against market declines, and to seek conviction-led returns. This stance is particularly pertinent with regard to bond indices, where, on account of their construction, the largest constituents are those issuers with the most debt.
A manager whose ability to deviate from the benchmark index is constrained may therefore be compelled to hold more of the bonds of highly indebted countries. Giving investment managers a wider, unconstrained mandate may be beneficial not only in terms of seeking returns, but also in managing risk.
PAUL MITCHELL of NEWTON continues: To manage a change from passive to active management, a charity must have a strong, dynamic working relationship with its investment manager. This can be aided by regular communications and meetings, which should help both parties to analyse and understand the changing situations of both the charity and financial markets, and to generate practical, workable solutions which can be implemented effectively in the portfolio.
It is incumbent upon the manager to explain clearly every element of an investment and its changes, and the potential impact; correspondingly, the charity and its trustees must have the courage and conviction to demand detailed explanations. Proactive management of the relationship by both sides should improve understanding, confidence and trust, and should help the charity to achieve an appropriate portfolio which is designed to meet tits objectives.
Yesterday’s just a memory, tomorrow is never what it’s supposed to be
Good managers will also ensure that the charity is made aware of any new legislation and the impact upon the management of its portfolio. Recently, there has been some good news for charities with permanent endowments, as on 31 January 2013, the Trusts (Capital and Income) Act 2013 became law. The Law Commission has recommended that the Charity Commission be given powers effectively to deregulate the giving of total return orders.
Hence the Trusts (Capital and Income) Act 2013 allows the Charity Commission to issue regulation setting out how trustees may invest without the need to maintain a balance between capital and income returns.
Once the regulations have been promulgated by the Commission, then, under Section 104A Charities Act 2011 as amended by the Trusts (Capital and Income) Act 2013, the charity trustees may resolve that the fund or a portion of it should be invested without the need to maintain a balance between capital and income returns and, accordingly, should be freed from the restrictions with respect to expenditure of capital that apply to it.
The trustees must be satisfied that it is in the interests of the charity that the regulations laid down by the Charity Commission should apply in place of the restrictions imposed under the trust deed.
Investment managers and trustees who do not consider such new legislation and discuss its potential benefits and drawbacks run the risk not only of forfeiting positive effects, but also of causing financial detriment to their charity.
PAUL MITCHELL of NEWTON says: A good working relationship between the investment manager and the charity is important at all times, and becomes even more so during difficult times. Good managers keep in regular contact with charities to discuss both the current situation, and to suggest changes that may be appropriate.
Full discussion of the relationship between risk and return, the effect upon income and capital and any impact upon fees is fundamental in reaching the best solution and building a long term relationship of trust. Change, whether from financial markets or from charity legislation, is ubiquitous, and should be embraced through activity and discussion, not filed away and ignored.
Yes, how many times can a man turn his head
pretending he just doesn't see?
Communication, training and administration
ROWENA WHITE of SARASIN & PARTNERS comments: Many would argue there is no such thing as an "average charity"; each charity has its own specific objectives and trustees can often approach their goals from different angles. When it comes to investing for a charity, there is therefore no single "correct" approach. That said, it is interesting to note that a number of charities end up following similar strategies, even if the path they took to get there varied considerably. Moreover, they will have considered a number of similar factors in their deliberations and engaged with their investment managers on many of them.
There are a number of ways that charities and investment managers can work together to achieve the best end results. A good working relationship which allows for clear communication, confidence and trust will lie at the heart of taking the right decisions at the right time and most importantly, having the confidence to stick with them in troubled times.
For a successful charity investment manager, there is likely to be significant variety across one's client base in terms of the strategies being followed. This is likely to include new charity clients seeking initial advice and long standing clients going through periods of change.
There will also be moments when the investment markets dictate that a strategic message needs to be broadcast across the entire charity client base. Is there a new asset class that client need to consider? Has the structural risk/reward associated with a particular investment changed for good? Have capital or income concentration levels changed in a market that requires changes to be made?
The key takeout here for trustees is that they need to employ an investment manager who is proactive in drawing their attention to strategic shifts in investment markets and who has the breadth of charity knowledge and experience to recognise the particular moment when a charity needs to think about a shift in policy. Strategy is not something that should be allowed to drift and is not something that should just be considered at a beauty parade or at a 5-7 year review.
A strategic asset mix which is in keeping with a charity’s particular requirements is the best protection in volatile investment markets. It is interesting to note that while long term investment portfolios may look remarkably similar, the proportion of their overall assets which may be deemed to be genuinely long term in nature can vary considerably.
ROWENA WHITE of SARASIN continues: This is where good and regular communication between manager and charity is essential. Understanding how the cash flow requirements of a charity are developing over the medium term and exploring the possibility of any unusual capital drawdowns (even if they are unlikely) is all important information for an investment manager.
The value of matching cash flows to liabilities was amply demonstrated in the volatile markets of 2000-03 and again in 2008-09 where those charities which had appropriate strategies – and just as importantly the confidence to hold their nerve – did not have to become "forced sellers" at the bottom of the market cycle.
Some of this good communication will come from regular meetings. It is quite common to have bi-annual meetings with the full trustee board, where recent performance is reported and future investment tactics are discussed. However, it is very helpful to have additional meeting with the finance director or an investment sub-committee.
So often at the larger trustees meetings, the investment manager’s report is part of a much bigger agenda and there is often not time to discuss any aspects beyond medium term performance. At smaller meetings where investment is the whole agenda, there is an opportunity for in-depth discussions on strategy and the charity’s developments.
It is also worth not underestimating the confidence trustees can be given through clear and eloquent presentations. Markets play on everyone’s emotions and the "behavioural" aspects of investment should not be forgotten. Doing the "right" can feel very "wrong" and it is very easy to be whipsawed in and out of markets. Presenting to charity trustees and executives and maintaining their confidence in your abilities, and just as importantly the strategy they are choosing to follow, is a rare but important skill given the very different backgrounds of the average group of trustees.
This brings us to trustee training: to achieve proper debate and understanding of the issues at hand, all trustees need to reach a certain level of investment awareness. In this, it is important that your investment manager has the ability to train trustees as and when required.
It is in an investment manager’s best interests to ensure trustees have a clear understanding of how they are managing their money. Not only will it result in more lively and healthy debate, but if trustees understand and follow the investment manager’s philosophy and strategic advice it is more likely to lead to a long and stable relationship. It is also a little unfair on those trustees with more investment experience to carry too much of the burden of investment responsibility.
ROWENA WHITE of SARASIN says: First class administration is important too and poor administration can easily shake the confidence of trustees. It is surprising how often that a failure in this department can be the tipping point for a charity sacking an investment manager even when everything else is going well. There is nothing more irritating than having to chase for that all important report or income forecast, or to have too little time to consider papers before a meeting.
Trustees should feel confident that their questions will be answered promptly and with the clarity they deserve – and that they have enough (clearly presented) information to hand to allow them to make informed decisions.
This leads us on to another crucial element of a good relationship: honesty, clarity and transparency – in all matters. As noted, the level of investment knowledge amongst trustees can vary enormously. However it is the investment manager’s job to ensure that all the trustees can interpret their reports accurately and with ease. If you cannot understand something, then the chances are you are not the only one! In most cases the blame lies with the report or the investment manager.
One of the areas where the investment management industry has received particular criticism in recent years (entirely fairly) is the "opaque" nature of management fees. It can be surprisingly difficult for trustees to identify charges and this isn’t the best point from which to build a trusting relationship.
Ultimately, trustees are the guardians of their charity’s funds. Good communication between the investment manager and trustees will lie at the heart of a good relationship and will form the basis for achieving the charity’s long term objectives. A good set of performance numbers can go some way to ensuring a good relationship but even the best fund managers have shown that they don't produce good performance numbers 100% of the time!
Therefore in the "less good" periods – be they relative or absolute – a relationship based on clear communication and trust will ensure that the trustees maintain confidence in both their investment manager's abilities and, perhaps more importantly, their own investment strategy.
Acting as genuine financial advisers
SASHA WIGGINS of BARCLAYS comments: Certainly, communication is the cornerstone of any healthy relationship and the working relationship between a charity and its investment manager is no exception. There are a variety of practical measures that can be implemented to facilitate proactive and valuable communication: monthly transaction updates, quarterly strategy meetings and annual reviews just to name a few.
Having said that, it is also dangerous to attempt to define the perfect relationship and servicing model which will ensure charities and their trustees have a feeling of comfort and satisfaction, because the reality is that every charity is unique and will have differing requirements when it comes to the relationship with the investment manager.
When selecting and working with an investment manager, charities should ensure that the service proposition of their investment manager is not prescriptive, is client led and that the investment manager is disciplined enough to understand the service required and flexible enough to deliver it.
Servicing models aside, building a relationship of trust between a charity and its investment manager should come from the basics: a genuine understanding of the operating business and its financial performance and projections, implementation of the most effective investment structures and a holistic approach to risk management. One would argue that historically, the investment management industry has sometimes failed in successfully executing these basics with its charity clients.
Whilst the intention has no doubt been there, the industry focus on providing solutions for long term investment funds may have clouded the overall role of providing financial advice to charities based on a deep understanding of the client and its objectives. That is a bold statement, however if you think about the typical relationship between a charity and its investment manager, it is also an accurate statement.
The typical approach often begins with working capital. A charity defines its working capital requirements setting aside an appropriate level of working capital funds, held and managed in an operational bank account. The residual funds are then allocated to a "long term" balanced investment portfolio and an investment manager is selected to manage the portfolio.
The board identify their return objective, risk tolerance and operational requirements in an investment policy statement and this policy effectively becomes the mandate for the investment manager.
The investment manager then builds a portfolio which aims to achieve the stated long term return objective, yet at the same time, needs to be aware of short term volatility and liquidity as this investment portfolio represents all the residual funds of the charity. The risk of such an approach is that this dichotomy leads to neither objective being achieved.
SASHA WIGGINS of BARCLAYS continues: Operationally, the charity and the investment manager typically meet quarterly or bi-annually to discuss the investment strategy and portfolio changes, however the conversation is generally focused on the long term portfolio. Whilst many investment managers would argue that this approach has successfully worked for decades, analysis of this approach raises two fundamental issues.
The first issue is that many charities define residual funds outside working capital as "long term" investments, and the second is that the interaction between a charity and its investment manager is often focused on the long term portfolio as opposed to the holistic financial position of the charity.
That being said, how could a charity address these issues and amend the way it works with its investment manager? It could begin by involving its investment manager, alongside its accountant in the budgeting process, enabling the charity to work in conjunction with its financial partners in establishing its current financial position and how that position is budgeted to evolve over the next one, three and five years.
This then leads directly into a conversation between a charity and its investment manager regarding the appropriate allocation of funds based on the budgets. Charities should have a clear separation between their short and long term funds. In other words, instead of having two pillars of investments being working capital and long term investments, charities could introduce a third creating three investment pools: working capital (less than 1 year), short term investments (1-5 years) and long term investments (5 years plus).
This clear separation between short and long term investment portfolios is driven by the collaborative budgeting process with the differing risk parameters and return objectives of each portfolio captured in a clear investment policy statement (IPS).
Whilst the long term portfolio might have a return objective of CPI + 3.5% and a growth focused strategic asset allocation, the short term portfolio would naturally be more defensive with the IPS covering short term investment issues such as permissible fixed income instruments, counterparty exposures, liquidity requirements and interest rate risk.
Each of these issues are complex and a charity needs to work with its investment managers in defining a policy which mitigates these risks. For instance, a counterparty section needs to stipulate the minimum credit rating per counterparty, permitted counterparties with reference to an approved counterparty list and the maximum absolute and/or relative limits per counterparty.
This does not mean that the short term investment portfolio needs to remain in an operational bank account. However, a blended portfolio of call cash, term cash and short duration fixed income will reflect the fact that capital preservation and liquidity are paramount.
SASHA WIGGINS of BARCLAYS says: Charities need to work with an investment manager which can execute across all investment timeframes. In other words, an investment manager which not only offers a long term investment solution, but also a treasury management capability for the charity's short term investment portfolio, providing centralised access and administration whilst still being managed with the rigour and risk focus of a long term investment portfolio.
The investment needs and financial sophistication of charities are developing and the investment management industry needs to follow suit. Investment managers can no longer simply focus on long term solutions, they need to act as genuine financial advisers in understanding the underlying financials of charities, partner with charities in the development of a comprehensive and clear investment policy and provide a platform to execute both their short and long term investment requirements.
Both sides having frank discussions
CHARLES MACKINNON of THURLEIGH INVESTMENT MANAGERS comments: For charity trustees, recent legislation has highlighted awareness of their responsibilities, and also their obligations to conduct themselves in a responsible manner. A direct consequence of this is that traditional methods of selecting and working with investment managers have had to become more formal and process-driven.
A charity trustee, particularly a chairman of the investment committee, will look at matters differently from a fund manager. So consideration of the inflection points in a charity’s investment life should come from both angles. The three main points are first, the appointment of a manager or managers, secondly working with those managers, and the third point is the inevitable moment when you wish to fire them.
Good practice is that most charities should review their investment strategy at least once every three years. The investment committee should review the capital and income needs of the charity over the coming three years. Once this has been done, it should review the investment managers and the strategy or benchmark which has been chosen to ensure they are in line with the charity’s current aims and expectations. For an incumbent investment manager, this is a time when a close working relationship with the investment committee and its chairman is to everyone’s advantage.
One of the most frequent areas of disappointment that arises is when the trustees have devoted significant time to thinking of what they would like their portfolio to achieve, but have not discussed practical limitations of how with their managers. Examples of this are numerous, but experience shows there are a couple of classic problems.
The most frequent is if a charity decides that a certain class of investments must be excluded from the investment portfolio, for example tobacco stocks. To a non-investment person, this seems like a simple request, but from an investment point of view, you need to have a clear definition of “tobacco stocks” and you also need a distinction as to direct or indirect exposure, and how precise must be the exclusion.
If the charity has had a close working relationship with its managers during the discussion, the manager will be able to direct it to strategies that will enable the satisfaction of its charitable aims within any selected restrictions and constraints, while at the same time helping the charity understand the effect on performance and the expense of those constraints.
CHARLES MACKINNON of THURLEIGH continues: The provision of income and its relationship with total return is another thorny subject, and is the cause of endless confusion. Some charities are only able to spend their dividend income and cannot spend capital. For many, indeed most, there is no such legal distinction, but trustees will nonetheless place an income target as part of the mandate. For an investment manager, this is can be a cause of endless frustration, as badly formed benchmarks or mandates drive you to making sub-optimal choices for fear of breaching your guidelines.
A simple example was in the markets leading up to the financial crisis in 2007/2008. Many charities had given their managers a yield target, and in some cases this was expressed not as a percentage of assets, but as a cash amount. As yield fell in early and mid-2007, this caused the managers to buy ever poorer credits in order to achieve the yield target, or to buy securities with higher and higher dividend yields, such as financial institutions.
This then meant that those institutions were doubly hit by the subsequent collapse in financial assets. Had the mandate been to provide total return, the managers would have been able to own a much broader range of investments, and would have suffered a far better outcome. As before, if both sides of the table could discuss the actual needs, a better outcome could be achieved.
The investment manager may be a helpful guide to charity trustees when it comes to establishing the benchmark or the investment strategy, but it is advisable to guard against the relationship becoming too close. Review periods must be flagged well in advance. This is also very important when trustees come to consider whether they wish to appoint more than one manager. Even small charities can own three different funds with different styles to provide for a balance and to reduce idiosyncratic risk.
During the investment manager’s tenure, it is of great importance that the trustees give (and the manager listens to) feedback on whether outcomes are in line with expectations. This is where the close working relationship can be of greatest value. If the manager knows something is wrong, or if the direction or the needs of the charity are changing, he may be able to correct it before it becomes an issue.
CHARLES MACKINNON of THURLEIGH says: All of these examples illustrate the importance of trust, respect and a professional relationship that should exist between a charity and its investment managers. This takes a strong will, but if as a trustee you do not feel that your manager is responsive to your concerns, you should sack him. Equally, if as a manager you feel that you are being set impossible targets, you should resign rather than wait to fail. The act of resignation should shock the trustees into considering if their demands are realistic; if it doesn’t, you were only going to fail anyway.
Deloitte has just published its latest survey, Surveying investments in the charity sector, which focuses, for the first time, solely on the reporting of investments. Investments account for 31% of the gross assets of the average charity in our sample of 100 charities with varying levels of income, and cash 8%, demonstrating the significance of decisions made by trustees on deploying their reserves and managing cash and investments.
It is the duty of trustees to make the best use of resources within their acceptable risk tolerance but, as discussed in our previous article on investments, this may not always mean safety first.
Investments need not be the traditional financial assets such as cash, stocks and shares but can include loans given to support other charities, and investment in other charities and organisations whose activities directly further the lending charity’s aims. Each investment should be assessed for the contribution it makes towards supporting the objectives of the charity, but need not be restricted to providing an income or capital growth: investment can be made to directly support the charitable aims.
A report into social investment by the Institute for Voluntary Action Research, commissioned by the Charity Commission, was published in March 2013 and suggested that the most serious barrier to social investment is the lack of understanding between investors, investees and charities (who could be either investors or investees).
In our sample only 10% made programme related investment and only 3% had inward investment through a loan, bond or other financial assistance. Although there have been some high profile cases the markets for social investment bonds and other funding are still developing.
The Deloitte survey considers both the quality of reporting and the information reported in the annual report and accounts of the trustees. The Statement of Recommended Practise 2005 (SORP) sets out a number of requirements for a charity holding material investments.
This includes the provision of details of the investment policy and objectives, and the extent to which social, environmental or ethical considerations are taken into account and investment performance achieved against the investment objectives set.
In our sample, an investment policy of some description was included in 74% of accounts and the investment objectives were described in 64%. However, the performance against those objectives was reported clearly in only 14% of accounts with a further 33% providing some discussion of performance but not in the context of objectives and therefore achievements.
44% of charities sampled disclosed investment restrictions; of those charities, 41% of the restrictions related to ethical policies and 42% related to the guidelines set by trustees for the mix of investment within their portfolio.
Trust law allows trustees to delegate the day-to-day responsibilities to a committee or an investment manager, whilst retaining their overall responsibility as trustees. The trustees must decide the parameters for the contract and/or terms of reference, and monitor performance against the contract terms.
29% of charities surveyed delegated management to a sub-committee and 12% delegated directly to an investment manager. 76% of charities surveyed had at least one investment manager and 7% had over three. Those charities with more that one investment manager tended to have segregated types of investment or portfolios with varying objectives.
The average mix of investments held by the charities surveyed was biased towards UK and overseas equities (43%), cash (26%) and fixed interest securities (21%) (see Figure 1) . Investment objectives focused on yield and capital maintenance (45%) and liquidity measures (30%) (see Figure 2) . The high level of cash holdings and liquidity targets may reflect both the current state of the market and a perceived need to hold sufficient cash to meet ongoing obligations.
The average return on investments ranged from 1% to 7%, with charities having higher cash levels and liquidity targets achieving on average a lower level of return. The smaller charities within our sample generated a higher return, which result appears influenced partly by the property element within the mix of investments and the greater focus on capital maintenance and yield objectives.
Figure 1: the average mix of investments within an investment portfolio (fixed and current) (%)
Figure 2: investment strategies chosen by different charities (%)
The SORP requires charities to disclose their costs of investment management. Only 58% of those charities surveyed clearly disclosed the fees that they paid to their investment managers.
On average, based on those reporting fees in our sample, investment management costs were 0.25% of investment balances (excluding cash balances, as many of these investments were held outside portfolios). Smaller charities in our sample paid slightly more, around 0.4% of investment balances, and the larger charities paying correspondingly less.
So are your investments working for you? Charities and trustees need to understand the impact of each investment they make: the costs, the benefits and what might be the most effective way of achieving the charitable aims. Trustees must make the best use of the charity’s resources, not just the incoming resources of the year but taking a holistic view of the charity’s reserves, investments and future objectives.
"Those charities with more than one investment manager tended to have segregated types of investment or portfolios with varying objectives."
"Only 58% of those charities surveyed clearly disclosed the fees that they paid to their investment managers."
Charity investors have had to contend with quite a lot of changes over the last few years. From volatile markets, new and interesting investments, quantitative easing (QE) leading to record low bond yields and interest rates. The update to the Charity Commission’s guidance on investment in CC14 offers greater clarity on how trustees can invest and how to meet their investment objectives given these recent changes.
The balance between meeting the immediate financial needs with future spending commitments has always been a conundrum when setting an investment policy. Do charities invest on a total return basis, taking profits in assets whose capital value has appreciated and spending this to supplement other income?
This notion has become more popular in an era of low income that we have experienced throughout the last decade. As the graphs for UK interest rates and UK government bond 10 year gilt yields demonstrates, the ability to achieve a relatively low risk income has been difficult in recent years. Savers have been particularly hard hit as bank deposit rates have been negligible, especially after any costs.
The Bank of England has so far purchased total assets of £375 billion, the US Federal Reserve has expanded its balance sheet to an eye watering US$3.6 trillion following asset purchases. Unsurprisingly there has been increasing talk in the markets of when will QE end and what will be the outcome on assets. The US Federal Reserve indicated in May that it might taper monthly purchases from US$85 billion to US$65 billion by September and cancel all purchases by 2014 if the underlying employment market and economy picked up to a sustainable level.
Meanwhile, Europe continues to pledge to do whatever it takes to keep the struggling economy outside Germany going. The European Central Bank's assets were worth 30% of gross domestic product compared to the US at 20%. In Japan, Prime Minister Abe’s economy policy, known as Abenomics, aims to increase its asset purchase programme by US$1.4 trillion in two years. In light of this, interest rates are likely to remain very low in developed markets for some time to come.
One of the consequences of the credit crisis has been for the financial regulators across the developed markets to introduce a policy of high bank capital, forcing them to buy many of the bonds from the respective central banks. Banks have also restricted their lending policies to corporations, charities and individuals following the boom years of credit seen before 2008.
During the credit crisis, companies have generally been efficient in cutting costs and reluctant to spend large amounts acquiring other businesses. Lower raw material prices and central government monitory stimulus of getting cash directly into the economy have also helped businesses survive the downturn.
Charity investors have increasingly been struggling with asset diversification to reduce overall risk and maximise returns in a low return world. Investing in bonds has been a profitable investment in recent years as demand and their perceived safe haven status has pushed up prices. Talk of tapering or a reduction of bond asset purchases by central banks has caused government bond yields to increase and prices to fall lately.
Many commentators view the risk of holding longer dated government and corporate bonds as a big risk to portfolio capital values. One of the ways charity investors have looked to overcome this risk is buying equity income funds. Equity income funds tend to invest in more defensive company shares. as these pay out a greater proportion of their profits to shareholders rather than reinvest in the business.
With growing profitability and cash sitting on company balance sheets, companies have been returning increasing amounts back to investors by way of dividends. As a growing number of markets have opened to foreign investors, we have seen increasing dividend payouts from international companies as they compete on a global base.
The Barclays Gilt Equity Study calculated that the average UK dividend yield since 1900 has been 4.5%. While the equity income concept is not new in the UK, as UK companies have tended to reward investors by way of dividend, it is interesting that we have seen an increase of funds that offer international equity income. Many fund managers now offer this and have seen significant flows of money invested in these types of investment through active selection of different shares.
As with all active investment, it usually comes at a cost. If we are in a period of low investment returns as many predict, avoiding unnecessary investment costs will enhance returns and that is why there has been a growing interest in passive or tracking funds.
These funds do not employ active management skills but give exposure to equity markets at the lowest possible cost to investors, by holding the constituents of an index to track its performance. The most commonly used passive funds are exchange traded funds (ETFs), which globally have USD148.5 billion invested across all asset classes.
Plain vanilla ETFs simply buy, hold and sell the underlying constituents of the index they are tracking and are known as physically backed. An alternative means of tracking an index is to buy an ETF that employs derivatives or swaps, which is called synthetic replication. These synthetic replication ETFs have caught the attention of the regulators who are concerned about their suitability for investors where there are risks of bank counterparty and collateral failure.
It is intuitive that charities should use low cost investment and ETFs should by default be a perfect investment choice for trustees. However, the complication and perceived risks that synthetic ETFs offer is partly why ETFs have not taken off with charities in the UK. That said, most fund managers who offer discretionary investment management to charities will employ ETFs in their range of fund and they are commonly found in charity portfolios.
Global income ETFs will follow indices that are dividend weighted. This means they ignore simple market capitalisation indices, such as the FTSE 100, and instead invest in the companies paying the biggest dividends, and are weighted accordingly so investors get the most exposure to the highest dividends. Theoretically this will maximise income.
While this process replicates the stock selection activities of active income fund managers, who aim to pick stocks that pay high dividends, it does offer cheap charges and the potential for underperformance through poor stock selection. Conversely, a good active manager will outperform their index after costs, although there are not many who can do this consistently!
Of course bonds and equities are not the only way to generate reasonable income. Property has long been a core asset for charities and many have done well holding physical property, often bequeathed by a generous donor years ago. As an asset, if it is invested in a diversified rental portfolio, property has some of the characteristics of a bond and some of a share. Like a share, you make more money if the economy grows so that rents rise and buildings are improved and extended. Like bonds, you have a bit more security over the income flowing from your investment.
Physical property, while a good asset to hold, does have the downside of high servicing costs and potential illiquidity if a charity wants to sell. Active property funds that pool investors’ money and invest into direct commercial or retail property are another popular route. There have been periods when these funds have been closed to redemptions, for example during the panic in 2008, so investors need to be prepared for this.
Another alternative are ETFs that generally invest into pools of real estate investment trusts (REITs). These funds are available for retail investors and offer high liquidity at a lower cost. The downside for this is that REITs, as listed property company shares, generally pay a lower income compared to physical property or managed funds, and they can behave more like an equity than direct property.
Finally, there has been a growing use of structured financial products typically offered by banks to reduce a charity’s risk or to achieve a specific investment objective. They generally invest with a link to a specific market and as a pre-packaged investment strategy usually based on a basket of securities or derivatives.
Like synthetic ETFs mentioned before, buyers of structured products need to have a full understanding of what they are invested in and how future returns are achieved. Products structured designed to achieve a high income usually do not provide any capital gains and are constructed in a way that unless the investor holds the investment for its full term, typically five to seven years, they forgo much of the predicted return. The costs of such products are often quite high and are taken by the provider at the outset of the investment.
In conclusion, charities have a variety of different assets and investment vehicles to choose from to achieve their financial objectives. Trustees need to be sure that each of these options is suitable for their needs and have a good understanding of how more esoteric investments work. Ultimately, while trustees may have little control over market direction or interest rates, they do have greater say over the costs of investment.
While there is a balance to be struck between investment performance, quality of service and costs, if charities are seeking total return or income they need to take care amid the complexity that faces them.
"Charity investors have increasingly been struggling with asset diversification to reduce overall risk and maximise returns in a low return world."
"One of the ways charity investors have looked to overcome…risk is buying equity income funds."
"It is intuitive that charities should use low cost investment and ETFs should by default be a perfect investment choice for trustees."
Charities face a variety of financial, operational and regulatory challenges in the prudent oversight of their organisations, and might be forgiven for relegating any discussion around responsible investment as "nice to do – but not now". This is understandable, but in the light of increasingly positive guidance from the Charity Commission, it could be a missed opportunity.
The Commission has happily moved away from a fairly rigid and inflexible definition of what charities can do in the field of "ethical investing", to one predicated on the risks arising from not doing it. In brief, CC14 (the Commission’s principal guidance on ethical and responsible investing), allows an ethical investment decision to be taken where there is a particular investment which conflicts with the aims of the charity, where it might result in the loss of supporters or beneficiaries, or where there is no significant financial detriment.
This final point is important, because it recognises that investment performance can be affected by corporate indifference to the environment, human rights or the communities in which the business operates. It therefore becomes perfectly admissible for a charity to require its investment advisers to take a broad based sustainability approach in the selection and retention of investments, over and above any specific responsible investment policy the trustees may themselves draw up.
Wider charitable objectives
The Charity Commission increasingly recognises that charities should consider investment behaviour in the context of their wider charitable objectives. The example of a cancer charity being "found" to have tobacco investments is only the most obvious case. Trustees need to be cognisant that how and where they place capital for the good of the charity has a direct bearing on how that charity may be viewed by wider society.
Trustees therefore need to understand how and where fund managers are investing, and to be able to take a view on both the appropriateness of any investment strategy and on individual holdings. This may be particularly challenging for trustees where investments are pooled. Whilst a charity is perfectly free to decide not to implement an ethical or responsible investment strategy, charity law suggests trustees should at least carry out a review and understand the potential reputational risks from getting it wrong.
A simple way to start would be to consider the following questions:
• Do investment objectives correlate with charitable objectives?
• Do the charity’s particular activities or rationale suggest the need for ethical exclusions?
• Do fund managers have the capacity, interest and experience to manage wider ethical and responsible investment objectives?
• Do fund managers have the appetite and skills to deliver a rounded ethical investment strategy, including positively screened investments, if the trustees wish to apply one?
A practical example
A practical example of how this can work to the advantage of the charity is to consider the case of BP. One of the UK’s largest corporations and very widely held in charitable portfolios, the catastrophic value destruction caused by operational failures on the part of BP and its partners in the Gulf of Mexico led to billions of dollars in liabilities and fines and a share price that has failed to recover three years on from the accident.
Charity funds might have to avoid trans-national oil companies on the grounds of high environmental and human rights risk. It would be logical to identify BP as particularly risky given its high propensity to oil spills and prosecutions stretching back over a decade. If the decision to avoid it had been taken, the charity fund concerned would have been insulated from this value destruction owing to its avoidance of the stock on sustainability and reputational risk grounds.
A focus on integrity, stewardship and responsible business practices that charity investors can bring to the table has never been more urgent. Whether it is excessive executive remuneration, the phone hacking scandal that engulfed the media, or the rigging of LIBOR and product mis-selling in financial services, the seemingly endless failure of business ethics and integrity – "failure to do the right thing" – is now seldom out of the news.
The financial services sector has been engulfed in almost constant scandal recently, but at random, one might cite the record fine of $4.2bn handed down to HSBC for facilitating money laundering in Mexico, and a fine of $667m penalising Standard Chartered for illegal money transfers.
What all these corporate events have in common is poor risk oversight. Because responsible investors analyse companies in a holistic way, considering the entirety of a company’s impacts and risks including the ESG (environmental, social and governance) factors, a more rounded perspective is often forthcoming.
RESPONSIBLE INVESTING ENTERS THE MAINSTREAM. The financial crisis has ignited a debate around responsible business and sustainable models of finance. Trustees, can, via their fund managers, bring to bear a strong influence on business behaviour but they are also driving new ways of investing. Gazing into a crystal ball, one can see further integration of relevant risks such as climate change, water scarcity and supply chain resilience into business and investment models.
Bringing about change
The integration of ESG (environmental, social and governance) factors into investment decision making is helping bring about change. It particularly challenges the failed short-termism of recent investment thinking, emphasising instead a long term sustainable focus on value.
One emerging trend that aligns well with charitable objectives is impact investing, often defined as investment that generates measurable social and financial returns. Originating in the US, these opportunities are attracting increasing interest from charities, philanthropic organisations and government as a means of harnessing capital markets to the delivery of social good. Industry research (Rockefeller Foundation) suggests that around 2,200 impact investments worth $4.4bn were made in 2011, showing that this is a fast maturing sector of investment potential.
By their nature, charities have an important role to play as responsible investors, whether through conventional ‘negative screening’ (the elimination of industries counter to the charity’s aims) or via positive screening and engagement, where the best, most sustainable companies are sought through fund managers exercising a stewardship role in the selection and retention of investments.
The choice of a fund manager is a crucial one for any charity manager, but some fairly straightforward questions might be posed so that trustees may properly assess their ability to integrate a socially responsible investment framework into the investment process.
Underlying ESG risk
Trustees will want to understand, for instance, the underlying ESG risk to their portfolio, and how this is managed. Are managers voting? How are they voting and how active do they appear to be? Are they engaging with companies on governance risk and seeking change or improvement? Have they avoided investment on governance grounds and why? Are trustees in receipt of a complete voting record and do managers publish their voting record in accordance with understood best practice?
The kind of issues managers are prepared to take action on is also instructive. Are the managers a signatory to the UN Principles of Responsible Investment? Are they willing to collaborate with other investors around significant issues? What types of issues are the manager focused on and what have been the outcomes of any engagement process? Is this published? How do managers engage internationally?
I would contend that in a globalised, complex world increasingly focused on resource constraint, climate change and human rights, monitoring ESG risk should be part of a charity’s due diligence. Trustees should routinely question and probe managers on governance and "non-financial" risk and understand whether they are active, competent and willing to act proactively in the best interests of their underlying investors on environmental, social and governance issues. If they hold BP, you may want to ask why?
"…charity law suggests trustees should at least carry out a review and understand the potential reputational risks from getting it wrong."
"The financial crisis has ignited a debate around responsible business and sustainable models of finance."
Since 2000, capital market conditions have made it difficult for many charities to meet their return objectives and simultaneously fulfil their fiduciary obligations. These challenges have been compounded over the past two years by a marked drop-off in donor gifts and governmental austerity measures. Indeed, donations in the United Kingdom have declined 15% in real terms to £9.3 billion during 2011–2012.
For most not for profit organisations – especially those already operating with limited staff and resources – managing in the current economic environment has been made even more difficult by the range and complexity of today’s investment opportunities.
Drafting an adaptable and effective Investment Policy Statement (IPS) can help charities stay on course, allowing investment managers working on their behalf to more nimbly avoid risks, catch tactical opportunities generated in turbulent markets and, ultimately, achieve the charity’s long term objectives. Importantly, such a policy also could better frame stakeholder expectations.
Further, placing an emphasis on risk metrics can give charity trustees and executives a clearer idea of the trade-off between the pitfalls in reaching for returns and the shortfalls inherent in playing it safe.
Rethinking the IPS
For many charities, the IPS does little more than express their aspirations and mission. Of course, we should recognise that the general adoption of the IPS since the Trustee Act 2000 marks a huge advance in general standards of investment governance. However, given the passage of time since, and the dramatic changes and complexities of the investment landscape—and the fact that most charities have moved from traditional stocks and bonds to portfolios that are more sophisticated and diverse—a far greater level of consideration is needed.
Even when conventional policy statements are more concrete, they tend to hamper success by including clauses that are too restrictive, setting inappropriate time horizons and neglecting to acknowledge risk that could undermine returns.
Instead charities should adopt an enabling policy; one that:
• Has horizons relevant to investments rather than a charity’s lifespan.
• Looks forward rather than backward.
• Is flexible enough to capture opportunity.
• Gives measures of expected investment risk the same level of prominence as expected investment return.
Rethinking time horizons
The starting point for this more constructive IPS is an appropriate investment timeframe for the assets that support a charity's mission. By precisely identifying a strategic timeframe (i.e a forward looking, 10 to 15 year interval), the IPS can shape more focused risk and return expectations. Referring to this interval when setting strategic asset allocations is sufficient to capture the economic and financial market conditions likely to influence portfolio performance and determine a portfolio’s contribution to a charity’s operating objectives.
Many IPS’s seek to support a charity’s desire to construct a portfolio with a maturity long enough to take meaningful risk for the benefit of asset compounding. Basing an asset allocation on excessively long time periods (30 years or more) can be misleading, as looking at such timespans offers no guarantee of approximating average returns. Rather than tacitly matching the investment time horizon with that of the charity, an IPS should be more explicit about the timeframe over which it is to be measured, and should be adjusted as global economic and investment market conditions change.
Many IPS’s also tend to base their strategic asset allocations solely on historical data and outdated preconceptions, or indeed find comfort in allocating in a manner common to other charitable organisations. This can be deeply problematic, as investment returns are unlikely to match those previously observed. Unfortunately, group behaviour is also no guarantor of success.
The UK charity sector has traditionally maintained higher allocations to domestic equities than was often observed in other countries. It is understandable that there should be comfort around such a diverse and developed market. However, the equity market experience of 2008 and the interruption to UK banking sector dividends in subsequent years of the financial crisis have challenged many notions that permanently endowed charities could and should withstand high levels of volatility simply due to their long term objectives.
Of course, there is no crystal ball, and one would not suggest that anyone’s forecast is going to be perfect. But it is evident that there is great utility in having an informed and well considered, forward looking viewpoint to shape asset allocations.
After the baseline strategic asset allocation is set, the IPS typically specifies a band around each allocation so that tactical changes can be made to take advantage of specific opportunities. Over the past few years, many investment committees have been more comfortable discussing prudent bands around asset allocation (which I would endorse).
However, narrow bands around volatile asset classes would compel investors to round up equity exposure in a protracted market decline or round down exposure in a relentless rally. For instance, during the equity market plunge of 2008, tight bands would have led a portfolio to continually buy into equities to maintain exposure regardless of the determined descent in stock prices.
Source: Bloomberg, J.P. Morgan. As of May 31, 2013.
* Allocation starts at 33.33% equities, 33.33% alternatives and 33.33% fixed income as of December 31, 1999, and is not rebalanced. Past performance is no guarantee of future results. It is not possible to invest directly in an index. For illustrative purposes only.
Even in normal economic and financial market cycles, there are many opportunities for enhancing return or reducing risk through judicious tactical changes to portfolio exposures that a tightly constrained policy band might preclude.
Both portfolio governance and performance could be better served by setting allocation variance bands sufficiently broad to accommodate either historical levels of volatility or volatility levels one expects to see. Depending on capital market assumptions, the odds are roughly 50-50 of not breaching 5% policy bands over the next five years. In the context of recent history and future expectations, widening the bands to account for meaningful market volatility simply makes sense.
Within reason, an IPS should seek to enable more than it restricts. This is not to advocate relaxing portfolio discipline or disregarding a charity’s preferences for, by way of example, constraints on the use of leverage or asset class diversification requirements.
But high level guidance may unintentionally handcuff portfolio managers, preventing them from using a fuller set of tools to increase returns or reduce volatility, let alone exploit investment opportunities that arise from market dislocations. For instance, an IPS may mandate that all property exposure be attained through property investment trusts while failing to acknowledge the exposure that can be achieved across core property without the volatility of the equity market.
The extreme markets of 2008 are littered with examples of the unintended impact of policy guidelines on investment performance. Futures managers and commodity trading advisers who could have provided vital diversification often found themselves constrained by overly explicit guidelines on leverage and transparency.
Return-focused policy objectives are the natural starting point for organising investment policy. But it seems just as important to have IPS guidance regarding risk parameters that are acceptable to the organisation. After all, yearly volatility, “drawdowns” and the “black swans” of unexpected events all directly impact returns.
Articulating a charity's risk tolerance also has the benefit of informing stakeholders of just how variable any given year’s returns may be. Volatility can be a key determinant in the compounding of portfolio returns. As such, some advance knowledge of the magnitude of risk inherent in a portfolio may assist in deciding between having the fortitude to maintain the course during unforeseen events and bailing out to lower portfolio risk precisely when risk should be increased.
With this in mind, it should be the case that the investment committee, the managers themselves and the stakeholders should be informed about risk, as well as return expectations.
An approach that enables portfolio construction within the confines of sound policy guidance makes sense no matter what the environment for investing may be. It is most essential in periods of modest returns and outsized risk.
Now more than ever, charities with investment assets should have their IPS’s go beyond an expression of goals and missions. At a minimum, charities should consider adding an appendix or amendment to provide greater analytical detail to help frame expectations. Measures of expected investment risk – annual standard deviation, drawdown potential and other gauges of illiquidity and volatility – should be given the same level of prominence in an IPS as measures of expected investment return.
Ultimately, a better IPS is about incorporating good governance. But equally as important, a good IPS is about shaping expectations for everybody involved, including the beneficiaries.
"…an IPS should be more explicit about the timeframe over which it is to be measured, and should be adjusted as global economic and investment market conditions change."
"Even in normal economic and financial market cycles, there are many opportunities for enhancing return or reducing risk through judicious tactical changes to portfolio exposures…"
"The extreme markets of 2008 are littered with examples of the unintended impact of policy guidelines on investment performance."
"At a minimum, charities should consider adding an appendix or amendment to provide greater analytical detail to help expectations."
With interest rates lingering at all time lows, investors which rely on the income generated by their cash and fixed income portfolios can often find themselves short-changed as inflation erodes the value of their assets. The challenge for charities and their advisers is balancing the apparently conflicting objectives of maximising income from investments in the short term, while also preserving spending power over the longer term and constructing their portfolios appropriately.
Since the introduction of the Trustee Act 2000, the investment universe available to charity trustees is now similar to that of an individual investor. Charity trustees have the ability to invest in all asset classes and geographical regions, whereas previously portfolio allocation was much more prescriptive. However, they also have a duty of care and the Charity Commission, which regulates UK registered charities, expects trustees to seek professional investment advice and emphasises the need to diversify their investment portfolio.
Against this backdrop, there are two common pitfalls that charities fall into in their approach to investing. The first is that a "cautious" attitude to investment risk can often draw a portfolio into a bond-heavy asset allocation, where protection from equity market falls comes at the inevitable price of sluggish growth at best.
The second is a situation where the investment strategy focuses on the understandable need to produce income, but at a level that does not reflect the reduced yield figures available today. Whilst these targets may have been achievable in the past, if they are rigidly adhered to and treated as targets rather than aspirations, the portfolio will inevitably become skewed towards high yielding assets and asset classes in a way that is potentially detrimental to long term return.
Furthermore, and perhaps of greater significance, is the potential increase in volatility of returns due to portfolio concentration of a skewed asset allocation.
For example, there was a situation in the run-up to the credit crunch where a charity instructed its manager to sell all government bonds, on the grounds that yields were declining, and reinvest in higher dividend UK “blue chip” shares, primarily UK bank shares. This had a catastrophic effect on both capital value and income by 2009 as bank shares either fell dramatically or were nationalised and dividends cancelled.
A PRAGMATIC APPROACH. One way that charity trustees can mitigate these pitfalls is by adopting a "total return" approach to portfolio management. Here, the manager is not bound by any specific income target, but instead aims to maximise the overall returns of the portfolio subject to the risk tolerance of the trustees. In effect, within an appropriate risk framework the manager is indifferent to whether returns are generated from income or capital growth and seeks to deliver an optimal risk adjusted "total return".
Higher total returns
If a firm income target is put aside, the manager is in a position to allocate capital between bonds, equities and alternatives (of various sorts) in a way that represents a "best ideas" portfolio. This is likely to lead to higher total returns, since any income restriction would usually be detrimental to a greater or lesser extent. The manager would thus be able to avoid holdings that were only attractive due to high yield levels.
Portfolio construction would be free to begin from an unconstrained starting point, reflecting the underlying appetite for risk. It is therefore important to undertake a full and in-depth client discovery process in order to properly understand the requirements, preferences and objectives of the charity in question.
If the conversation begins with a yield target, it is all too easy for it to end there as well, with the meeting of that figure becoming the sole criterion considered. Once one is able to look at a broader range of factors, it is far more likely that the resulting portfolio will meet the trustees’ needs and be one with which they remain happy.
Alternative asset classes
Conversely, a rigid income target will often lead to a simple cash-equity-bond asset allocation being recommended. The absence of a demandingly high income target will allow low or nil yield alternative asset classes, such as funds of hedge funds or commodity biased collective investments, to be introduced.
This can contribute to lowering the overall level of market (equity or bond) correlation and reduce the overall risk exposure of the portfolio, thereby leading to improved risk adjusted returns. This broader and more pragmatic approach aligns well to the Charity Commission’s emphasis on appropriate diversification.
INCOME ASPIRATION. In practice, trustees still often have an income target in mind, despite having set a total return mandate. This can be referred to as an income aspiration, and often leads to the interesting situation that the target is mentioned only when it is not met. In this situation the income requirement remains in the background, but is still a factor to be considered. This is probably a reasonable compromise between the desirable total return approach and the realities of a trustee’s responsibilities, and the pressure to meet current financial constraints.
OPPORTUNITIES EXIST BUT EXPECTATIONS MATTER. Fundamentally, investors must be realistic about obtainable returns and this can sometimes mean that expectations need to be recalibrated. It is no longer tenable to expect the double digit returns seen in the past. The age-old principles of diversification and selectivity have become ever more important as investors look to balance short term income with long term returns, and adopting a total return strategy can help achieve this.
Like many investors, the challenge for charities is developing an optimal portfolio that achieves the stated investment objectives while remaining cognisant of the overall risk tolerance. This requires a candid conversation between the charity and the chosen adviser to clarify core investment objectives and the risk/return profile to arrive at the most appropriate asset allocation.
This will ensure a balance is achieved between income today and future growth to protect the real value of the portfolio. An over-emphasis on income levels could reduce the long term investment returns and increase portfolio volatility, due to the restrictions on diversification that such a policy would require.
"…the manager is not bound by any specific income target, but instead aims to maximise the overall returns of the portfolio subject to the risk tolerance of the trustees."
Changes in Charity Commission guidance (Charities and Investment Matters: A Guide for Trustees — CC14) have challenged charities' assumptions regarding investments. The guidance outlines principles to assist the trustees in their investment decisions. The key concepts here are principles and guidance. There is no "one size fits all solution" as trustees must make decisions based on the particular circumstances of their charity. However, that is not the same as saying the status quo should not be questioned.
This article is a challenge to charities to probe and investigate how hard their investments are working for them. There are no right or wrong answers here; rather questions that charities should ask themselves. These questions will help them to analyse and understand their own needs and requirements before putting in place a successful and robustly monitored investment strategy.
Many charities hold significant reserves in the form of cash accounts or investment portfolios to support future projects, or are holding assets yet to be assigned to a project. Such portfolios have often been put in place many years ago and, oversight in terms of the level of risk or the target return may not always have been maintained. There is a considerable difference in the return potential, and therefore risk impact, of different investment strategies.
This may have the ability to impair or enhance a charityâ€™s ability to fund future projects, fundraise and increase profile. Interest on cash held on deposit has never been lower and with such uncertainty in global markets it is right that charities consider:
• Is a cash return sufficient with inflation running at over 3% against a cash yield of around 0.5%?
• Where an investment portfolio is utilised, how much risk is being taken and what is the impact on the charity if there is a marked drop in asset value of the reserves?
• How does the investment time horizon compare with the need to disinvest to support projects?
KEEPING PACE WITH INFLATION IS NOT RISK FREE! Following the global credit crunch, cash rates collapsed from 5% in April 2008 to 0.5% in March 2009, where they have remained. Inflation on the other hand, since 2009 has averaged over 3%. Therefore in real terms charity cash investors have been losing purchasing power at a rate of around 2.5% per annum.
This is of particular relevance to charities whose future expenditure is more likely to be linked to inflation than base rates. Additionally cash investors have needed to consider the security of the balance sheets on which their assets are placed. While the worst seems to be over in terms of banks defaulting, these incidents can result in depositors losing money.
Although cash portfolios are currently resulting in a loss of assets in real terms, taking investment risk to try and outperform inflation and achieve a more meaningful return can result in capital losses. Such capital losses may have an impact on the charity's ability to support its work. This can also be true where income from investment portfolios is used by the charity for the day to day running of the charity.
Where investment risk is being taken, charities need to consider how to assess downside risk. There is always a range of potential outcomes from an asset portfolio and some outcomes will have consequences.
WHAT IS THE INTENDED PURPOSE OF AN INVESTMENT PORTFOLIO? Answering this question is not straightforward and often it is informative to initially consider what the objectives are for any particular pot of assets, in particular:
• How important is capital preservation?
• What is a reasonable return objective to target in the current environment?
• How much risk is it reasonable to take to achieve that?
• What are the income requirements?
• What are the consequences of not achieving the objectives?
• What are the time horizons?
Many investment portfolios will be earmarked for future use and capital losses can result in failure to undertake important projects or budgets being rewritten. Where portfolios are earmarked for future use charities should carefully consider the timeframe for completion, the required capital value and the impact of postponement and therefore the required investment return and level of risk than can be bared to achieve said return.
Equally where portfolios are being run for â€œrainy dayâ€ scenarios, charities should consider what scenarios would result in the need to dip into these assets and importantly how the portfolio of assets will have performed going into this scenario.
For example, if a portfolio invests wholly in equity investments, and in a scenario where global markets continue to fall in value with cash pressure on consumers, it is likely that charitable donations could significantly reduce at the same time as investment portfolios are falling in value â€“ an unhelpful combination.
An alternative type of investment fund is one used to generate an income stream where the income is then used to fund charitable work/ongoing projects. In these circumstances capital preservation may be less of a concern as the charity may be able to withstand capital movements so long as the income being generated is not impaired.
For example, if an investment fund holds a bond paying a reasonable rate of return, there may be less concern if the market places a lower value on that bond since the charity is not intending to sell the bond â€“ so long as it is confident of getting the coupon value every year and the capital back at the end of the term.
Additionally charities should consider the liquidity needs for investment portfolios. The more liquidity required (e.g. for short term capital projects) the more the investment portfolio should be weighted towards assets less likely to â€œshockâ€ in value over the short term.
AN UNCERTAIN MARKET ENVIRONMENT. We are in a unique market environment characterised by uncertainty. The global debt crisis continues with the burden having shifted to central governments some of which have responded by pumping liquidity into their local markets. Although equity markets have been strong over the last 12 months and arguably remain reasonable value based on fundamental factors, global markets remain unbalanced and the extent to which central governments can support their banking sectors will continue to be tested in local markets.
Global economies have yet to fully deal with the debt crisis as we move into an age of austerity where low growth could be the new norm and global markets become inextricably interlinked. Equally the impact of the extraordinary amounts of quantitative easing that continues to take place in the UK, US and Europe remains the world largest inflationary experiment, with exit strategies and knock on impacts largely unknown.
In this environment cash may be seen by some as a safe home for capital stability but generates little income for investors and even keeping pace with inflation requires investors to take a certain level of investment risk.
In contrast to cash, since the turn of the year, global equities have performed strongly whilst income yields available on fixed income securities remain at very low levels. In these difficult markets where volatility can result in unexpected underperformance and secure assets risk capital depreciation, charity holders of investment portfolios would be wise to both reassess their risk profiles within portfolios and challenge their investment managers on how they balance the need for meaningful return against the risk of capital losses.
In such difficult markets it is important for holders of investment portfolios to review the risk frameworks for their investment portfolios to ensure:
• Appropriate governance structures are in place to review and challenge investment managers
• Risk and reward trade-offs are properly understood and appropriate restrictions are in place to avoid investment portfolios taking too much (or too little) risk for the required return
• Income requirements are clear and portfolios are geared to deliver income without having to eat into capital
• Appropriate fees are being charged. In a low yield environment where cash is yielding 0.5%, and both treasuries and corporate bonds yielding less than 5%, fees can have a more meaningful impact on the overall return.
GOVERNANCE IS KEY. Charities with significant investment portfolios should also consider the governance structure around the management of portfolios. Often investment portfolios are left in place to run without appropriate challenge and without independent assessment on whether they have been successfully managed and represent value for money. Furthermore mandates for investment portfolios can be fairly bespoke with grey areas between delegated responsibilities.
There are broadly two types of delegation involved in running an investment mandate: firstly, where the client sets the asset strategy and delegates the implementation of the strategy to an investment manager, and secondly where no specific investment strategy is set but risk is defined through a process of profiling.
Charities should be aware of the level of delegation within mandates and challenge themselves whether their role is active enough. They should be reviewing the elements of delegation within a mandate. This may include, for example, reviewing the provider, the benchmark strategy against which the mandate is run and the purpose/objectives of the strategy.
Overall, the impact of asset returns in these portfolios can be significant for the running of a charity. The assessment of the performance and risk within such mandates is key in such volatile market conditions. Additionally the governance structure around these mandates needs to be robust with charity investors fully aware of the decisions they themselves are taking and the potential impact of those decisions.
THE TASK IS CLEAR, ALBEIT FOR CHARITY TRUSTEES IT WILL BE A CHALLENGE. Charities should regularly monitor and justify their positions and be prepared to adapt as circumstances demand. However, no change in investment strategy should be taken without diligent review and professional advice.
"…in real terms charity cash investors have been losing purchasing power at a rate of around 2.5% per annum."
"There is always a range of potential outcomes from an asset portfolio and some outcomes will have consequences."
"…capital preservation may be less of a concern as the charity may be able to withstand capital movements so long as the income being generated is not impaired."
"…charity holders of investment portfolios would be wise to both reassess their risk profiles within portfolios and challenge their investment managers on how they balance the need for meaningful return against the risk of capital losses."
It has been a common view in the financial markets over the past 3 years that bond markets represent poor value given the extremely low levels of yields available. Despite this, returns from bonds over the last 18 months have been strong. Government bond yields dropped sharply during the eurozone crisis in 2011 and corporate bonds came to the fore in 2012 as yield spreads compressed.
Investors, both retail and institutional, have herded into bonds. Bond funds saw record inflows and institutions continue to switch away from equities and into bonds in pension portfolios. The motivation for this huge asset allocation is partly sentiment driven but for institutional investors, subject to ever increasing regulatory scrutiny, the problem has been the ever decreasing discount rate.
This has pushed up the value of long term liabilities and in many cases, despite the strong rally in equity prices since the 2008 financial crisis, pension schemes remain in deficit (Figure 1).
Further to this, trustees of pension funds and charities can hardly be blamed for seeking to take a safety first approach having had to endure high levels of volatility and poor returns in equity markets over the last 10 years. The global macro risks faced today look to be a greater challenge for policymakers than anything they have faced in the previous two decades.
Equally, as central banks have forced down yield curves using quantitative easing, issuers have been more than happy to supply bonds to the market at record low levels – there was around $4 trillion of global issuance during 2012.
But the concern is that many investors, including charity investors, have rushed into bonds without necessarily understanding the risks, namely that UK bonds are more sensitive to changes in yield than ever before. In fact sensitivity has increased by 25% over the last 10 years (Figure 2).
If we were to see any kind of normalisation of real yields, so called safe haven bonds could give surprisingly negative returns (not good news for charity investors) – and move from risk free returns to return free risk. For example, on a 10 year gilt the yield needs to rise only 0.27% to wipe out the income received for a whole year. This is the scale of the market movement seen in the space of 10 trading sessions at the end of June.
Moreover, high quality corporate bonds are likely to behave in a very similar way to government bonds after the significant yield compression that we have seen over the past year. Back in 2008 there were a number of blue chip issuers such as HSBC, Rio Tinto and Altria which issued bonds at yields above 8% – these bonds now typically trade at large premiums and yields of around 2-3%.
So both gilts and higher quality corporate bonds now trade with yields which offer charities negative real returns and no protection against any increase in inflation. Many institutions have switched over to the index linked market in an attempt to preserve the real value of their clients’ assets. Here though the risks are just as acute if we are to see any kind of normalisation of real yields. Even in a higher inflation environment a valuation adjustment in the form of higher real yields could eliminate all of the upside.
One has also observed that specialist lenders are raising capital in the closed end funds space to fill the gap left by banks in many sectors. Lending margins are attractive and these funds can offer attractive yields. Where the funds have robust discount control mechanisms and decent liquidity these are very good substitutes for conventional bond exposure.
A good example of this is the Starwood European Real Estate Finance fund which was recently issued on the London Stock Exchange. Due to the fact that banks are withdrawing from lending to commercial property, Starwood (a well-established property lender with a good track record) is taking advantage of the attractive yields on offer. The portfolio is projected to offer a yield of 8-9% before expenses and will have positive sensitivity to rising interest rates.
In my view charity investors need a highly adaptive and flexible strategy within bonds and should probably be prepared to take some moderate risk in order to generate a reasonable return.
Diversification across senior secured loans, floaters, callable subordinated bonds, high yield and some closed funds will give the optimum combination of decent income and low sensitivity to changes in yield. Such an investment policy within bonds can still deliver decent returns for charities, even against a weak government bond market.
"…trustees of…charities can hardly be blamed for seeking to take a safety first approach having had to endure high levels of volatility and poor returns in equity markets over the last 10 years."
The development of investment markets over the last decade, culminating in the credit crisis and volatile markets have caused charity trustees to focus on the key issues when making investment decisions. Clearly risk and return remain essential determinants, but a few other factors have become dominant when assessing investment, namely transparency, complexity and costs.
Many trustees have a long term time horizon when investing on behalf of a charity and are prepared to take risk. Many will delegate the investment decision to a qualified fund manager to meet the specific investment requirements of the charity. Many trustees still have a traditional view of investments and tend to favour an actively managed fund or investing directly into specific shares or bonds. None of this is wrong or bad, but there is an alternative approach to charity investment by using passive funds to gain exposure to markets or assets.
Passive fund investing has gained traction in the UK over the last decade and is somewhat confused as there are a number of terms or variations of the theme; occasionally referred to as passive funds, index funds, tracker funds and exchange traded funds or products (ETFs and ETPs).
The concept of passive investment is not new. The idea was developed by John Bogle in the US who took his university thesis, "Mutual Funds can make no claims to superiority over the Market Averages" and founded The Vanguard Group in 1974. Simply put he thought that active fund managers, after costs, rarely outperformed their respective benchmarks. He launched the first index fund in 1975 to track the performance of the US equity market (S&P 500 Index). Seasoned investors at the time criticised this method of investment stating that “they couldn't believe that the great mass of investors are going to be satisfied with receiving just average returns".
Growth in popularity
Numerous other institutional investors in the US established similar passive funds for pension funds in the mid 1970s. Notwithstanding the sceptics, the passive investment market grew in popularity and became available to retail investors. Vanguard funds mushroomed and the firm became one of the largest fund management groups globally. The birth of the exchange traded fund occurred in 1993 with the Standard & Poor's Depositary Receipts (SPDR) commonly known as ‘Spiders’, and also based on the S&P 500 US stock market index.
Barclays Global Investors developed this idea in 1996 with the launch of World Equity Benchmark Shares or ‘WEBS’. This enabled US retail investors to invest internationally with ease through a New York Stock Exchange mutual fund for the first time. Barclays subsequently rebranded its passive fund range as iShares and the business was sold to BlackRock in 2009. State Street Global Advisors were also an early developer of ETFs, entering the market in 1998.
It is therefore no coincidence that BlackRock iShares, State Street and Vanguard are the leaders in the passive fund market, although many new entrants have launched their versions of ETFs in recent years. These have notably been large retail banks or financial firms such as HSBC, Credit Suisse, UBS, db x-trackers (Deutsche Bank), Source (Bank of America/Merrill Lynch, Goldman Sachs, J.P. Morgan, Morgan Stanley and Nomura), Lyxor (Société Générale) and others. Passive funds have grown in popularity in Europe over the last decade and this has mainly been through ETFs. Their growth in net new assets has been exceptional and by the end of September 2012 there were US$1.85 trillion invested in 4,748 ETFs or ETPs globally according to BlackRock research.
ETF Growth Rate
While passive funds and ETFs can be used for short term trading, they are best and mostly used for long term asset allocation. It is increasingly recognised that the long term performance of a charity investment portfolio is derived from which asset it invests into rather than the stocks it holds. Passive funds have an important role to play in this respect.
There are many myths and concerns surrounding passive funds, so to assist charity trustees, there are some useful facts that should assist with their general understanding.
STRUCTURE. Passive funds in general are unit trusts or open ended investment companies (OEICs) which are priced closely to the net asset value or NAV (the collective value of the assets held in the fund). They are not listed on a stock exchange but traded through a fund manager. An ETF differs in that it is listed on an exchange and offers daily liquidity when the market is open. It has the advantage of a higher governance structure, similar to an investment trust and must comply with the exchange listing rules.
Passive Fund Structures
HOW DOES AN ETF WORK? An exchange traded fund (ETF) is an investment vehicle which is constructed as an open ended collective investment scheme and trades like an individual security on a stock exchange.
ETFs are UCITS III compliant (European fund management regulation), open ended collective investment funds which seek to track the performance of a benchmark index. ETFs are the most common exchange traded product available in Europe and globally today. ETFs can either track their index through holding the underlying securities, so called physical-based, or alternatively by holding a derivative, called synthetic or swap-based. ETFs offer investors transparent, flexible, liquid and cost-effective access to virtually any asset class.
In many ways, they are similar to any other collective investment, such as a common investment fund or unit trust, but ETFs provide investors with a variety of benefits over traditional funds:
LOWER EXPENSES: In general the total expense ratio (TER) for ETFs ranges from 0.5% to 1%. This compares favourably to an active fund where typical charges vary between 0.75% to 2% or more.
TRANSPARENCY: Most ETFs disclose on a daily basis the exact holdings of the funds so you always understand precisely what you own and what you are paying for.
FLEXIBILITY: ETFs can be bought and sold at current market prices at any time during the trading day on a recognised exchange, unlike unit trusts, which can only be traded at the end of the trading day or once a week.
INCOME: Most ETFs distribute income, which will be based on the underlying assets held.
DIVERSIFICATION: In most cases, an ETF will offer wide diversification across an entire market by holding all or most securities in the index.
NO ACTIVE MANAGEMENT RISK: An ETF simply tracks a particular market or index and doesn’t make judgments on the constituents of the index it follows. Therefore there is no risk that a fund manager who actively picks underlying investments will do a bad job and underperform the index or benchmark they are following.
Buying an exchange traded fund gives exposure to a specific market. In essence, ETFs provide the building blocks to produce tailored investment portfolios. Investors can buy several ETFs over several markets in order to implement a tailored asset allocation strategy.
ETF Replication Methods
ETFs either purchase all the assets which make up the index they intend to follow or partly so. Alternatively they may enter a derivative contract to gain exposure to an asset. Funds which invest in commodities and other esoteric assets offer higher risk as they introduce higher counterparty risk.
|Full replication||The fund buys and holds all the index constituents in the weightings defined by the index it invests in.||Usually found in liquid developed indices, such as the FTSE 100 index.|
|Optimised or Sampled replication||This involves buying not all, but a portion of securities within the index in order to track the index’s performance.||When it is not considered cost-effective to buy all of the securities in the index. For example, in the case of MSCI World index, the iShares ETF holds around 700 companies whereas the index holds more than 1800 constituents.|
|Synthetic or Swap based replication||The fund holds liquid assets as collateral and purchases a total return swap agreement (derivative) with a swap counterparty which delivers benchmark return to the ETF.||The value of the swap or derivative is limited to a maximum of 10% of the value of the fund. In most cases, the fund holds collateral worth more than 100% of the fund.|
Swap-based funds will have a higher risk profile when compared to their physical-based equivalent, because of their exposure to the swap counterparty. However, under the UCITS rules, this exposure is limited to a maximum of 10% of the value of the fund and in most cases this is much less. Therefore should the counterparty fail the maximum loss to the fund is 10% as the underlying collateral will be returned to the investor.
In order to mitigate the risks of the existing swap-based ETF structures, various ETF providers offer funds which have multiple counterparties and hold more collateral than the value of the counterparty exposure. The quality of the collateral and over collateralisation help investors to protect against counterparty default risk at all times. Most providers of synthetic ETFs share daily collateral and index holdings, swap counterparties and aggregate swap exposures on their websites to provide transparency in line with the physical-based ETFs.
EXCHANGE TRADED COMMODITIES (ETCs) and EXCHANGE TRADED NOTES (ETNs). ETCs issue debt securities which trade on exchanges offering investors direct exposure to commodities. By investing in ETCs investors gain the desired exposure without the need to trade physical commodities or commodity futures contracts. Similar to ETCs, ETNs are debt instruments which tend to be issued off the balance sheets of the issuing entity, typically a bank or special purpose vehicle.
ETNs offer exposure to a broad range of asset classes and trading strategies. ETNs are neither funds nor exchange traded funds and the level of counterparty risk can vary depending on the issuer. They are therefore considered to be higher risk and not suitable for retail investors. In addition, those funds which use derivatives to gain exposure to a commodity may find the performance varies significantly from the price of the commodity it tracks.
|Exchange Traded Commodity (ETC)||ETC can be either physically backed, or derivative-based on a particular commodity or basket of commodities.||ETCs are neither funds nor exchange traded funds. Physical ETCs are fully backed by the commodity they track, typically precious metals.|
|Exchange Traded Note (ETN)||Debt instruments based on more esoteric asset classes, such as volatility indices.||Issued off the balance sheet of an issuing entity, typically an investment bank, therefore offering higher counterparty risk.|
HOW TO SELECT A PASSIVE FUND. The selection of a passive fund or ETF is no different from any other type of investment. The first step starts with the selection of an asset, such as a share, bond, property, etc. Having decided which country or sector, the next step is to review the available universe of passive funds available. This can be done on a number of comparative fund analysers or simply via providers’ websites or even Google. Key factors include:
• Knowing what the fund owns and understanding the index it is following.
• Physical or synthetic replication?
• What are the total costs?
• Understanding the fund’s liquidity.
• An evaluation of the fund provider.
It is important to remember that every index is unique. Two indices which cover similar areas of the market – even with similar sounding names – can differ greatly from each other and will possess their own unique risk/return profile. This will have implications for performance.
Costs are a key consideration when selecting a fund. Understandably, the TER – the total paid to cover the costs of fund management, trustees, licensing and operational costs – is an integral part of the choice making process. ETF portfolio managers can also take a number of actions that provide additional revenue which can be used to offset these costs, such as securities lending or the proceeds of the swap agreement. The "true cost" is usually the difference between the performance of the fund after all costs and the index it follows. In many cases this can be as low as 0.05%.
A fund which is highly liquid will be easier and more cost-effective to trade. Conversely, poor liquidity can translate into difficulties in buying and selling, in addition to higher trading costs.
The size, scale, expertise, and commitment of a fund provider are important and vary significantly. While the popularity of passive funds has increased dramatically, there are a number of recent ETF providers who have closed funds and pulled out of the market recently as their operations have proved to be sub scale.
The Exchange Traded Fund Universe
THE RISKS ASSOCIATED WITH PASSIVE FUNDS. As with all investments, a charity trustee should carry out proper analysis or take professional advice before making a purchase. While passive funds offer many advantages over active or traditional funds, there are risks and associated concerns that should be considered:
Like all investments there can be market, custodian and counter-party risks as outlined above.
POOR PERFORMANCE. Some ETFs may not track the index closely and have a large tracking difference.
CHOOSE YOUR INDEX CAREFULLY. The index which is being tracked may not reflect the performance of the asset class the investor wants to track, for example a fund which invests in ‘Emerging Markets’ can vary between Asia, Latin America and Eastern Europe resulting in very different results.
FUNDS WHICH GEAR OR SHORT A MARKET. Some funds can go "short" or sell shares they do not own in the anticipation that a market will fall and they can buy back the shares at a cheaper price (inverse). Alternatively a fund may borrow and leverage the assets in the fund (typically x2 or x3 the value of the assets). These types of ETFs are only suitable for intra-day trading by qualified investors and may not behave in the way expected over a longer period.
REGULATION. ETFs are not covered by the Financial Services Compensation Scheme if they are bought by private individuals without advice from an FSA authorised entity.
In the past year many regulators have cast a spotlight over the passive fund market, especially regarding ETFs. The focus has been towards synthetic ETFs, which have attracted regulatory attention from the Financial Stability Board, the International Monetary Fund, the Bank of International Settlements and the Financial Services Authority. Areas of concern include the lack of transparency in products and increasing complexity, conflicts of interest between fund providers and swap counterparties and lack of regulatory compliance.
There is concern that misuse of ETFs or the excessive use of derivatives could pose a systemic risk for financial markets. Given the significant growth of ETFs and their availability, it is reassuring that the regulators are giving this area attention. In reality, the systemic risk is much lower than expected as all ETFs accounted for 3.4% of global market capitalisation by September 2012, so have a long way to go before they compete with active management or pose systematic risks considering the overall size of open global derivatives which amount to US$3 trillion.
VERY IMPORTANT FOR CHARITY INVESTORS. Passive funds have a key part to play in charitable investment and are growing in funds under management. Contrary to myth, passive funds are an established method of investment and are here to stay. The recent strong growth in passive investment funds, during volatile markets, has aroused the attention of market regulators, but they have recognised that in their simplest form ETFs are a safe investment.
When used sensibly for long term asset allocation purposes they offer a simple, transparent, liquid and low cost investment alternative to active fund management. For these reasons alone, charity trustees should consider them as a core part of any portfolio.
"While passive funds and ETFs can be used for short term trading, they are best and mostly used for long term asset allocation."
"An ETF simply tracks a particular market or index and doesn't make judgments on the constituents of the index it follows."
"ETFs either purchase all the assets which make up the index they intend to follow or partly so."
"The selection of a passive fund or ETF is no different from any other type of investment."
"A fund which is highly liquid will be easier and more cost-effective to trade."
"As with all investments, a charity trustee should carry out proper analysis or take professional advice before making a purchase."
The burden of responsibility for trustees is increasing daily. The increased scrutiny combined with a low return equity environment and recessionary pressures on donations means many charities are faced with a bleak financial future. As Sir Donald Nicholls said in the Bishop of Oxford case, "Most charities need money; and the more of it there is available, the more the trustees can seek to accomplish."
So it is prudent to examine how those who manage and invest charities’ precious funds are conducting themselves. On examination what is evident is an investment industry, which while certainly not operating illegally, is regrettably in the main not operating quite as it should. Investment companies can sometimes be masters of opacity. Charities have to don a detective deerstalker and rummage around to uncover the truth about their investments – particularly in terms of costs.
Many investors simply cannot find out or understand how much their investments are truly costing, and as one charity trustee has been heard to complain, he knows the legs are being pulled from under him, but he just can’t find the information to prove it.
Small part of the total cost of investing
Most investors will know the Annual Management Charge (AMC) and maybe the Total Expense Ratio (TER) and understandably, but mistakenly, believe this is a true and full reflection of the total cost. But often it can be a relatively small part of the total cost of investing.
Even though the TER is meant to include some of the extra costs, e.g. custody and administration costs, performance fees, and the extra costs of any underlying funds, some managers do not include all the underlying fund costs and exclude performance fees in their reported TERs. Any dealing costs associated with the daily management are totally excluded as are many of the other costs.
As earlier as 2000, an FSA research paper found that in the UK only half the overall fees and costs were disclosed to investors. I have calculated that one of the largest hidden elements, dealing costs, is currently running at £2.7 billion pa in UK retail funds alone. Using the same assumptions, these costs would be £18.5 billion pa in the whole UK savings and investment industry. (I have used Morningstar data and Investment Management Association figures.)
The components of these dealing costs are: *dealing commissions: the price paid by the fund to the dealer for transacting; *stamp duty: tax paid on trades; *bid/ask spread; *market impact cost: the cost caused by the impact of a trade on the market for a security, e.g. a large fund may drive down the price of a security it is selling; *opportunity cost: the difference between the price at the time of the decision and the price obtained at execution that is not attributable to market impact. If a fund spreads a trade out through time to diminish market impact, opportunity cost can rise if the price moves adversely in the interim.
Impact of hidden dealing costs
The Investment Management Association (IMA) recently looked at the costs of buying and selling shares within traditional, actively managed UK equity funds. It found that the average reported cost of this dealing was 0.39% pa. However, its analysis only looked at the largest funds which as a function of their size normally deal less, and excluded the normal market maker buy/sell spreads which every fund manager faces.
When you adjust for these factors it is self-evident how much the hidden dealing costs amount to in an average fund – some funds may be considerably more and some considerably less.
How iceberg fees work
In essence, fund management fees can be seen as replicating an iceberg. Investors are shown the tip but rarely the whole iceberg; and it is often the part beneath the surface that can cause the damage. Fund managers’ iceberg fee scales tend to be highly complex with a myriad of fees lying below the surface. For example, some managers charge take-on fees, some charge for the custody of assets, or valuations and some inflated dealing commissions.
I was rather startled recently when I saw a press release from a large investment organisation announcing the launch of a special charity product with an attractive 1% annual management charge. The director of a foundation I am involved in telephoned and was told repeatedly that this was the only fee and it was "all in".
The company "forgot" to mention that the product was a fund of fund structure investing in other managers’ funds, the costs of which they had neither quantified or even mentioned in their advertising. The real cost was probably double the advertised rate.
New code of conduct required
My belief is that regulators and the industry should work towards a new code of conduct and ethics that will force the industry to reveal in one number the true cost of investments. The key is to work out ALL the costs and fees whether one-off or recurring, fixed or volatile, that come out of your original underlying investment returns so an investor can work out their "net" return. Accountants have successfully managed to achieve this for years by using firmly established principles.
DOES FEE TRANSPARENCY REALLY MATTER? Yes – in a period of low overall returns whether you are paying 1% or 3% pa, on underlying returns of 5% pa, can make a difference between keeping either 40% or 80% of the returns in your charity's pocket. Compounding has been described as one of the great wonders of the world – 2% compounded over 20 years is a staggering 49%!
Recently the highly regarded academics Dimson, Marsh and Staunton estimated that the real return on equities going forward was likely to be 3%-3.5% pa. If your charity is paying all-in costs and fees of, say, 2% to 3%+ pa, what is the point of investing? You could well be better off simply leaving your money in the bank.
Of course, costs are only one element, with risk and returns being the others, but only by properly calculating the costs can investors make truly informed decisions.
HOW WOULD IT BE POSSIBLE TO SAVE 2% PER ANNUM AS ABOVE? Consider the following and you should be able to do so.
Reduce investments in very high turnover funds – take UK equities for example, buying and selling a typical share including stamp duty, commissions and spreads is likely to cost 1%. So if your manager is turning over UK equities at 100% pa, which many are, it will be adding 1% pa to costs. Some managers use index funds to reduce these costs – using exchange traded funds avoids stamp duty completely.
Be very wary of traditional "fund of funds" – even if your manager is buying these funds at their special "institutional" rate, it is probably adding about 0.95% pa to your costs (assuming a typical 0.75% pa annual fee and 0.2% pa fund expenses). Some managers reduce these costs by either holding the securities directly or through low cost index funds.
Traditionally invested has been via funds but the more modern efficient method is via a managed account. Some managers offer managed accounts without charging the extra custody and administration costs, which often saves a further 0.2%.
Ask whether you are receiving anything extra by selecting a manager with higher costs to you?
Utilising the above actions can save as much as 2% pa. Of course this does not guarantee a good return – if the manager is investing in assets with little return then no matter how low their costs, you will still receive practically no returns. There needs to be a sensible balance between costs and returns.
"Many investors simply cannot find out or understand how much their investments are truly costing…"
"If your charity is paying
all-in costs and fees of, say, 2% to 3%+ pa, what is the point of investing?"
As a trustee reviewing a depleted endowment after some tumultuous years how should you assess whether you have chosen the "best" managers for your funds, or more importantly, whether they have been doing their best for you?
Study the report card
Choosing a fund manager can be daunting. When conducting a "beauty parade", most advisors suggest that all those present mark the fund manager on a number of attributes ranging from presentation skills to the clarity of their investment philosophy. So how do you know whether or not you have made the right choice? After a poor year, do you fire your fund manager on the spot, regardless of previous record? Probably not. One bad year isn't necessarily a disaster but you do need to demonstrate that you have done your due diligence.
Like any sensible appraiser, I propose we study the report card, not only for the most recent term but over a reasonable timeframe to assess whether or not your fund manager is meeting your expectations. Consider the following criteria, marking each category and see how they add up. I have allocated a maximum potential percentage score to each criterion.
PERFORMANCE – MAXIMUM PERFORMANCE SCORE 25%. Did the portfolio produce the returns you expected or were they much worse (or better) than the trustees anticipated? If the returns were behind the agreed benchmark, how did the portfolio fare relative to the peer group? Was the performance achieved by taking the appropriate (and agreed) level of risk?
COMMENT. It is tempting and pertinent to award the highest marks for achievement or "outperformance", but performance must be measured with care and over a sensible timeframe. The new Charity Commission guidance suggests that trustees review their manager "from time to time"; most trustees interpret this to be once every 3-5 years.
Given the volatility we have witnessed over the past 10 years it might be wise to consider a longer assessment period. In the case of underperformance, trustees must be clear of the cause, be assured that any issues have been dealt with and importantly, won’t recur.
Consider a longer assessment period
INCOME – MAXIMUM PERFORMANCE SCORE 10%. How much income did the portfolio generate? Too much or too little, or was it exactly the amount the trustees had asked for at the start of the year?
COMMENT. Generating an agreed level of income from a portfolio can be a fundamental part of the manager's role. Achieving the correct balance between income for today's beneficiaries as well as allowing for future capital and income growth is arguably a charity manager's most challenging task. The dire combination of dividend cuts, depleted bond yields and dwindling interest rates come all too often hard on the heels of times of need, just when charitable grants are of the essence. To disappoint at such a time is a failing on the part of your manager and should be marked harshly.
Missing an income target
To lose capital value (although you may not have actually realised a loss) is unfortunate, but to miss an income target is careless and means disappointing a beneficiary. Conversely a portfolio might produce excessive income, possibly at the expense of capital growth: not quite such a black mark but still an unwanted surprise for the trustees. In short, trustees should rely on their manager to provide a steady income stream, or at least to communicate early if circumstances change.
IMPLEMENTATION OF POLICY – 10% MAXIMUM PERFORMANCE SCORE. Are you happy that your manager is investing the portfolio in accordance with the agreed strategy? Is the investment policy still appropriate or does it need updating? Should you consider another investment approach to complement your existing strategy? Absolute, relative or target return? Alternative assets, currency hedging, dampened volatility, socially responsible investment…have you considered all of these?!
COMMENT. The jargon can be overwhelming for trustees and every year it seems another, "better" way to achieve the perfect portfolio emerges. Whilst one should not dismiss new investments or alternative strategies straight off, it is probably best to start by reviewing your own Statement of Investment Policy to see whether it is still applicable.
Make sure that your manager is investing as the policy dictates, then discuss any changes you are considering. And if necessary, ask them to write a strategy paper assessing your overall investments and requirements. A good manager will pre-empt any matter that needs addressing.
The current investment climate will bring all number of challenges to which trustees and managers alike will need to adapt. Consistency is also imperative; try not to change your strategy too often as this can lead to the wrong decisions being taken.
STABLE ORGANISATION AND TEAM – MAXIMUM PERFORMANCE SCORE 10%. Is your manager part of a well established organisation? Is the team stable? Does the company attach sufficient emphasis to charities?
COMMENT. An ongoing, strong reputation for any financial company is clearly key. It is important however to ensure that the answers you sought and received when you first appointed your manager remain valid. A change of ownership is not necessarily a negative but it might mean that senior management's eye is taken off the ball for a time.
When there's an unhappy ship
An unhappy ship is made obvious by an unusual increase in the turnover of staff and this can quickly upset the balance within a team. Politics are prevalent in any firm, but if you do your research, you will be over halfway to finding out what is really going on behind the scenes. Make sure your manager is concentrating on your portfolio and not on his/her personal exit strategy.
COMMUNICATION AND PERFORMANCE – MAXIMUM PERFORMANCE SCORE 20%. How efficient is your manager and do you get on with them? Do you receive regular, clear reports and are they explained to the trustees properly? Could your manager be concealing a poor investment? Are they burying that all important figure?
COMMENT. First class administration should be an easy win but it is surprising how often that a failure in this department is the tipping point for losing a client. There is nothing more irritating than having to chase that all important report. Forming a close relationship with trustees is possibly one of the fund manager's most critical roles. It is a case of clear communication, confidence and trust.
Questions should be answered promptly
A strong rapport is essential and I don't mean that you should be wined and dined by your manager every week (don't worry, the Bribery Act has put a stop to all of that). Rather, you should feel that your questions will always be answered promptly and with the clarity they deserve.
During your meetings, ensure that the trustees can interpret the reports accurately and with ease. If you cannot understand something, chances are you are not the only one.
COSTS – MAXIMUM PERFORMANCE SCORE 10%. While we are on the subject of honesty, what about the fees you are paying? Are they competitive and what is the true picture?
COMMENT. There is nothing more frustrating than a trustee believing that they are paying much less for a service than they are in reality. Whilst we are all under pressure to reduce our fees there aren't many industries where there is still such a lack of transparency over the true annual cost of running a portfolio.
Even a recent survey of charity managers' fees resulted in a fictional report as a number of managers had not answered the questions correctly; not an encouraging outcome.
Yet it is very simple: any fund manager should be able to provide you with a summary of the total costs you have incurred. This includes all charges that are added to the quoted annual management fee such as broker commissions, administration, third party fund fees and VAT.
VALUE ADDED FOR CHARITIES – MAXIMUM PERFORMANCE SCORE 15%. So what is it that really makes the difference to our trustees? What helps them conclude after such a dreadful year that their managers are in fact doing their best under difficult circumstances.
COMMENT. The answer lies somewhere in a much over-used expression which is the "value added" that a fund manager provides. Not many firms, in my experience, devote enough resources to the charity sector. They might have their names up in lights as members of various charitable think tanks, but do they really have a presence?
Devoting resources to the charity sector
Charity fund management has always been a difficult beast to categorise, falling somewhere between the institutional and the private client. It is, nonetheless, quite different and should be treated as a niche area for all number of reasons. A credible manager dedicates a significant part of its business to charities,and offers regular charity seminars and trustee training.
Many charity managers write topical papers dedicated to issues that are facing charitable trustees: how ethical should your portfolio be? What is an acceptable and manageable level of income? How much risk should you take? How globally can you invest? All of these are valid questions and must be addressed and debated regularly if your manager is to attain the highest marks.
You are doing well if your manager scores 100% in the above test, but even a consistently high mark in each category with a 70%-80% result and they deserve to be in the top set for another year.
It is extraordinary to think that we are in the fifth year of the financial crisis. Five years is considered a reasonable timeframe to invest (and to make) money from real assets such as equities and property yet many of us, both trustees and fund managers, will feel uncomfortable as we evaluate our funds. Take comfort then from the last five or ten report cards and consider the above criteria as part of your review process.
Or perhaps I have just made a difficult subject more complicated and you pose one simple question to your trustees: "Are you sleeping at night?" If the answer is positive, then your managers are probably doing their best for you.
"It is not unusual to find that the worst performing fund manager one year enjoys the best performance the following year."
"Generating an agreed level of income from a portfolio can be a fundamental part of the manager's role."
"Make sure that your manager is investing as the policy dictates, then discuss any changes you are considering."
"Make sure your manager is concentrating on your portfolio and not on his/her personal exit strategy."
"There is nothing more irritating than having to chase that all important report."
"A credible manager dedicates a significant part of its business to charities, and offers regular charity seminars and trustee training."