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Assessing investment manager performance

FROM THE EDITOR: This survey on how to assess the performance of investment managers is in effect a debate between our contributors with each coming from completely different view points, and involving some very outspoken comments. The result is that charity trustees and finance directors are presented with a wide range of considerations which, according to our contributors, they must address.

There are four contributors to this debate so far (others are expected). They are Simon Hallett, Philip Todd, Gina Miller and James Pike.

Please read the comments of all. In the current economic situation, when charities' finances are under such pressure, any reputable view on charity investment performance needs to be given full consideration, even if the trustees or finance director have their own firm views. There is nothing wrong with firm views these troubled times, but there is with fixed views.

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Choosing benchmarks and understanding performance

SIMON HALLETT of investment advisory firm CAMBRIDGE ASSOCIATES comments: What are we really trying to do? This is the first question trustees should ask themselves when considering investment performance. As time passes collective understanding can change, especially where there is turnover among the trustees. So the first place to start is the Statement of Investment Principles (SIP). It is also a good moment to reflect on whether the objectives were right (or realistic) in the first place.

Investment objectives encompass a number of dimensions: most obviously return and risk, but what does risk mean to you? When considering long term capital, the risks are generally twofold: 1) not preserving the real value of capital after spending (not earning enough return) and 2) having to cut spending in the short term (too much short term downside).

Rather than asking how much risk you can tolerate, a better question is, what is the maximum pain you can endure? This will tend to focus the mind on the measures that really matter. Specifying a maximum tolerable loss in any one year can be a helpful proxy for short term spending risk and generally has resonance with committees.

Talk of measures leads naturally to benchmarks. There are basically three approaches: absolute return, index benchmarks or peer groups. While absolute return is what you actually want to achieve, it is an aspiration, not something that is investible or realistic over all time periods. It is hard, therefore, to use as a benchmark.

Equity and bond indices represent something that you could invest in cheaply and passively. If a weighted combination of equities and bonds captures most of the assets in which a manager invests and has volatility consistent with your risk tolerance, it should prove sufficient as a high level benchmark.

Peer benchmarks also show you what you could have achieved but are prone to survivorship bias and cannot represent your own objectives. In any case, the returns of the WM charities benchmark look very much like an 80:20 combination of equities and bonds.

All three of these measures are informative but when assessing performance over periods up to five years, focus on an index-based benchmark agreed upon with the manager and documented in the SIP.

Now to the performance figures themselves. Most trustees understand the need to think in the longer term about investment decisions, but behavioural psychology becomes a problem here. No one wants to be associated with failure, while action seems more responsible than inaction. Despite mountains of evidence to the contrary, investors cling stubbornly to the belief that recent performance is predictive of future success.

Unfortunately, and as a number of statistical studies have shown, hiring and firing based on trailing three-year performance measures is probably the worst thing you can do. What can trustees do about this? Two things: 1) understand why performance is what it is and 2) understand how investment decisions are being made and who is making them.

To diagnose performance issues you need to know five things:

1. Assuming an active manager, how are they expecting to add value? By asset allocation, picking stocks, or picking other managers?

2. Do they have a particular bias that means they will do better in some environments than others?

3. Are they overtly trying to limit downside or focusing primarily on returns?

4. For what kind of environment were they consciously positioning?

5. Can they give you a coherent idea of what worked and what didn’t for the period in question and is this consistent with 1-4?

SIMON HALLETT of CAMBRIDGE ASSOCIATES continues: The objective is to understand whether performance was consistent with what one would have expected. If the market collapses and the manager says it has been following a defensive strategy, it should have outperformed. Likewise if the market has surged, don’t be surprised if a cautious manager which prioritises downside protection underperforms even its own benchmarks.

Understanding the who and how of investment decisions enables trustees to rate the significance of performance issues and organisational changes. If the same team has followed the same systematic process for a number of years, it may experience extended periods of poor performance and be able to recover. It can also tolerate modest turnover in membership without causing a problem.

Performance issues should be considered very seriously if associated with some major change in the team, leadership or the named portfolio manager. This is especially the case where the investment approach is predicated not on a transparent process but on the unique “skill” of some named individual. Overall organisational issues should not be dismissed either. Changes of ownership, business problems and sustained staff turnover can get in the way of rational investment decisions. They can also indicate poor firm culture or alignment of incentives.

SOME FINAL TIPS. Evaluate managers regularly and scrutinise both good and bad performance. Perform your initial review based on the history and written materials, and only after that set up a meeting. Make sure you set the agenda in advance to address your key concerns – don’t let them take up your time with economic guesswork, etc. Be flexible on timing to make sure you can speak to the right person.

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Simon Hallett
Cambridge Associates' Simon Hallett – focus on an index-based benchmark agreed upon with the manager and documented in the Statement of Investment Principles.
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Judging on the whole service proposition

PHILIP TODD of INGENIOUS ASSET MANAGEMENT comments: Trustees typically ask investment managers to look after or "manage" their charity's investments in two different ways: either trustees buy a product or they "buy"/pay for a service.

PRODUCTS. If trustees invest in an investment product, typically a fund, such as an investment trust, a unit trust or a common investment fund, when judging performance the focus should be on investment performance. For trustees to be able to judge performance, the fund should have certain characteristics and the reporting information provided by the investment manager about the fund should be comprehensive and helpful.

DESIRABLE BASIC FUND CHARACTERISTICS. There should be a clear and unambiguous statement of investment objectives. There needs to be a single benchmark – for example, an index against which the fund's performance is compared. There must be clarity as to the maximum and minimum percentages of the fund that will be held in cash. Also necessary is clear statement as to the time period over which the manager wants to be judged . If a manager has long term horizons then looking at performance over 3 or 6 month time periods may not be very informative.

INFORMATION TO BE PROVIDED BY THE INVESTMENT MANAGER. There should be information about the performance both of the fund and the benchmark for varying time periods: since launch/inception and annualised since inception; for calendar years; for rolling 3 or 5 year periods; for 3, 6, 9 and 12 month periods. You will need to know about the standard deviation, a measure of investment risk or volatility. There should be information about the Sharpe ratio, a risk adjusted measure of performance – a higher Sharpe ratio means better fund performance relative to the risk free rate on a risk adjusted basis.

If there is an income objective, you will need details of the actual annual income distribution since launch. If the investment objectives make reference to maintaining or increasing the real value of capital and/or income then RPI (or CPI) information should be provided since inception.

If investment managers do not provide this information as standard, trustees should ask for it. Only when armed with this information can trustees start to judge an individual fund or make meaningful comparisons.

SERVICE. When trustees appoint an investment manager to manage a portfolio, they usually agree to pay an investment management fee. Although this fee is typically linked to the value of the portfolio (a good incentive for the investment manager to protect or increase the value of the portfolio), the amount paid is often a significant sum and trustees should be judging the investment manager not only on the investment performance (see above and which can be applied to a portfolio) but on the quality of the whole service provided. Service can be broken down into three main areas – communication; performance and risk management; and level of engagement.

COMMUNICATION. This is all about communicating clearly and responding quickly. As a minimum, trustees should expect: timely valuations, accounting information to meet SORP (Statement of Recommended Practice) requirements, and internet access. Trustees should also expect an accessible investment manager who attends meetings, answers emails and who provides an update ahead of any meeting in which the investment portfolio will or might be discussed; any member of a finance or investment committee should feel able to ring or email their investment manager.

PERFORMANCE AND RISK MANAGEMENT. Performance should be reported quarterly but judged over longer time periods, say 3, 5 or even 7 years. But an investment manager should always be able to explain performance. One area of performance which deserves more attention is an understanding and explanation of how much risk is being taken to deliver that performance.

PHILIP TODD of INGENIOUS continues: The Charity Commission guidance reminds us that setting investment objectives is not about avoiding risk but about recognising it and managing it. Investment managers should be able to quantify the risk being taken and the trustees must feel comfortable that the level of risk being taken is acceptable.

LEVEL OF ENGAGEMENT. Do the investment firm and the individual investment manager really understand that the investments are an integral part of the life and work and ethos of the charity? Is the trustee's ethical stance just a nuisance and prevents the investment manager from buying a favourite overseas fund, or does the investment manager work hard to accommodate it? Has the investment manager read your latest report and accounts?

Your investment manager should be helping you to make your charity better. An investment manager should be someone who you respect not because they talk a different language but because they take an interest. If your charity is a permanent endowment fund or is a mandate where you choose only to spend the income, such as perhaps a bursary fund, does the investment manager understand that the level of income generated must increase each year at least in line with "educational cost" inflation, and ideally increase more than that so that the number of bursaries can increase. If this process has not started at a low enough base and is not achievable, has your investment manager voiced their concerns?

In conclusion, investment managers should understand just how accountable trustees have to be. As the public's awareness of and interest in charities increases, particularly the awareness of charity donors, investment managers must work harder at helping trustees fulfil their responsibilities and should expect to be judged on their whole service proposition.

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Philip Todd
Ingenious' Philip Todd – investment managers should understand just how accountable trustees have to be.

Being aware of the true reality of costs

GINA MILLER of investment firm SCM PRIVATE comments: One could argue with considerable reason that the current system makes too many UK fund managers masters of smoke and mirrors and opacity. The truth is that with the present poor practices, poor transparency, poor price competition and poor performance from numerous traditional fund managers, the odds are stacked against charity investors making consistent positive returns on their very precious investment pots.

Of course the most important measure is the actual performance of charity investments after all costs. This is crucial in these uncertain and volatile times where charities are facing difficult fundraising environments and rising costs at the very same time as increasing demand for their services. Positive performance matters more than ever.

In my view, a minimum of three years and ideally five years should be the time horizon to properly judge a fund manager. But as important as the return is how the manager achieved this. Was this with very high levels of concentration in a narrow range of assets or securities? How liquid and marketable were these securities and how might they have fared in worse times?

Volatility is one measure of risk but it is not comprehensive and can be misleading. Is it really not risky to lend to western governments for 10 years and get back just 1.5% pa, substantially less than inflation? The volatility number would say no. Reason would say yes.  

How consistent is the approach of the manager? It is good to be flexible but there should be limits. A constant change of views shows a manager to be reacting rather than anticipating the whims of the market and suggests little in the way of fundamental conviction. This may be reflected in dangerously high portfolio turnover rates (PTR) whose associated costs are hidden when things are going well, but become badly exposed when decisions are less effective.

The performance should also be considered against costs. How efficient is the strategy and the manager in controlling and reducing the total costs so that more of the underlying returns get passed back to the charity? Often higher costs lead to more risky investments as the manager is forced to run up the down escalator and invest in lower quality bonds or equities in the hope that higher returns will offset higher costs and higher risks.

THE FEES ICEBERG. It is scandalous but true that, on average, investors are not aware of the full cost of their investments. This may not have been crucial to making informed decisions or judging a fund manager's performance in the past high return environment. But as we go into a low return investment landscape where some academics are either predicting the death of equities or a 3%-4% equity return environment, every penny or percentage point counts.

Like an iceberg, investors normally only see the top third of the fees they are paying for their investment. The remaining two thirds hidden under the surface can erode investment returns so that investors are effectively paying fund managers to lose their precious money. Sadly, the UK regulator and most UK fund managers have not changed this most unfortunate system under which everybody blames everyone else but no one stands up to properly change the system or do more than the minimum required.

For example, in the popular fund of funds sector, the typical fee that most investment houses seem to have "magically" alighted on for charities is 1% pa. But add in dealing costs which are typically another 0.5% pa, the underlying fund costs and other costs – and the true cost of investing is closer to 3% pa. When you then add in inflation of say 2%, your fund would have to be returning over 5% for your charity to be making real returns and not be eating into reserves.

GINA MILLER of SCM continues: Whilst many fund managers obviously like to charge higher fees for "active" fund management, often truly active fund management is not evident in reality. There are few asset allocation changes or many funds are simply closet index tracking, or even holding as much as half their assets in index funds anyway. As UK fund managers do not have to show or publish their holdings in full, this lack of transparency again allows for another debatable industry practice.

Combine all these factors with falling donations, rising costs and rising demand for services and the charity investment sector is faced with bleak days ahead.

The IMA Investment Management Association) and the FSA (Financial Services Authority) say it is not about costs; investors should judge fund managers on performance. So let's look at performance. The table below shows the odds facing investors when investing in traditional active funds. The chance of an active fund manager consistently outperforming the index over three consecutive years is just 4%.

PUTTING THE ODDS BACK IN YOUR CHARITY'S FAVOUR. In my view, the most sensible academically and statistically proven alternative investment strategy is to spread your risk via more diversification into different assets and more diversification within these assets (i.e. index funds) whilst investing efficiently to lower the overall costs that come from the underlying returns. Again the academic research shows that 91% of returns come from asset allocation rather than stock picking, yet most fund managers spend their time concentrating on the other 9%. No other industry concentrates its time on what counts the least.

Charity trustees and finance directors need to ask the awkward questions and not rely on fund managers supplying all the necessary information that will enable truly informed judgments and decisions. As the economic uncertainty is set to continue, fund managers need to be forced to behave transparently, to remember whose money they are investing and – particularly in the charity investment sector – to remember the human impact of looking after charity investments.

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Gina Miller
SCM's Gina Miller – investors normally only see the top third of the fees they are paying for their investments.
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Expect explanation and communication

JAMES PIKE of J O HAMBRO INVESTMENT MANAGEMENT comments: Whilst the principle of investment performance is simple – your assets have grown, shrunk or remained flat over a particular period – understanding what drives the return is important. An investment manager should never presume that trustees are investment experts. Having performance clearly explained should assist a board of trustees in evaluating a manager’s credentials in a beauty parade and help them assess an incumbent manager’s work on the existing investment portfolio.

You should expect performance statistics to be outlined clearly and concisely, providing the framework from which your investment manager can explain his or her positioning. Is your manager able to articulate as well as quantify recent performance? Attribution is a crucial element in this process and should form part of a review. The attribution should be structured in a way that matches your manager’s investment process and should highlight areas of strengths and weaknesses.

The relative performance contribution should also be deconstructed into tactical asset allocation, stock selection and currency effects. This level of information should already be widely used by your manager internally, so don’t hesitate to request that this forms part of the information provided at your periodic reviews.

It’s understandably tempting to react to negative short term performance figures, especially given market conditions over the last five years. An explanation of how your manager has constructed the portfolio along with their rationale is important, particularly if they are making aggressive adjustments in the teeth of a storm. It is often a costly move to "de-risk" at this time, as many found out to their cost when sentiment recovered from the darkest days of 2009.

The rationale should be articulated in the context of the agreed longer term strategy and your selected benchmarks. Underperformance of any benchmark in the short term should not necessarily trigger alarm bells. There may be many different explanations, not least the construct of the benchmark itself, which makes sense when looked at in terms of capital potentially at risk in the portfolio (gilt exposure naturally springs to mind here), so take time to examine and discuss these together.

In periods of sustained downside volatility, investment managers should be flexible enough to provide additional information to help fully explain the charity’s position at this time. Information relating to the maximum drawdown relative to the strategic benchmark and market indices are examples of additional material which could be included. This should provide an indication of the manager’s ability to limit losses and preserve capital in bear markets.

Frequency of reporting can, though, cloud perspective. Whilst it’s important to keep on top of performance, biannual reviews should be enough. However, even if the board are comfortable with their strategy there will definitely be some "speed bumps". Getting your core strategy or asset allocation right at the outset is a large part of being comfortable, or not, with a fall in value when it comes. Time spent exploring why a certain strategy might be right for your charity with your manager is well worth the diligence.

JAMES PIKE of J O HAMBRO continues: Even with a sensible spending policy and cash "buffer" in the bank, a portfolio these days is often relied upon more than in the past, particularly where funding is tight and expenditure still has to be met. Cash flow can be planned meticulously by the finance team but many charities find extra funds are required and the capital of the portfolio has to be utilised more than originally intended. There’s nothing necessarily wrong with this; it is after all what investment funds are often meant for.

Discussions with the manager about the fine tuning of your objectives at the time of awarding them your mandate can be a sign of things to come. A well managed "one size fits all" approach may give comfort to many boards and may also be entirely appropriate, though you will likely find little flexibility in terms of catering for any nuances peculiar to your charity’s circumstances. Make sure those you’re in discussion with are running your portfolio, report to you and have the authority to make changes if applicable.

The bottom line is obviously important, but is not the only component to monitor. Other aspects of the "service" a manager provides should also form part of the mix. Is your investment manager flexible? Are they a strong team? Are their communications and responses timely? What is their administration like? Do they have a back office in-house? Can they raise funds at short notice? Are they able to adapt the originally agreed mandate and the house management style to fit your charity’s more specific needs in the current economic climate?

It’s important that the manager can listen to your requests to change and be dynamic, but not be cavalier and dismissive in these difficult markets. Whilst there are common investment goals across most charities, creating a portfolio specifically for your charity within a solid investment framework should be easily attainable, even for a modest investment pot.

An investment manager is there to provide your charity with a service, which should go beyond the pure management of your investable assets. A proper personal relationship with your manager helps – even in a technology driven world.

Essentially, the watchwords should be "communication", "flexibility" and "preparedness".

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James Pike
J O Hambro's James Pike – in periods of sustained downside volatility, investment managers should be flexible enough to provide additional information to help fully explain the charity's position at this time.
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Selecting an investment manager

FROM THE EDITOR: This is a series of comments on what you should be thinking about when you select an investment manager firm for your charity. The commentators in this feature give a variety of views on what they think are key aspects for you to consider as you are faced with what will be an extremely important decision for your charity. If you get the decision wrong there could be, at the very least, considerable ill feeling between the parties and, at the worst, some really bad investment results which could even seriously undermine your charity's finances.

The contributors to this discussion are: Nick Sladden, Mark Cummins, Oliver Burns, Richard Macey, Tim Maile, Richard Nunneley, Charles MacKinnon, Ruby Sandhu, Helen Besant-Roberts and Heather Lamont.

Please read the comments of all. Remember that once you have chosen an investment manager firm to look after your charity's investment you will be locked into the relationship for a few years, so you should be truly comfortable and confident about the relationship from the very start. If you have any doubts of any kind during the selection process you should resolve them before making any final decision.

You probably know this already, as you no doubt are an experienced trustee or finance director. However, think for a moment about your relationship with your investment manager during the current or past mandate. Has it all been sweetness and light? Were there any problems which you wish hadn't arisen? Has everything gone so well that there is nothing different you would do this time when it comes to the selection process? Maybe the comments of our 10 contributors below will make you have another think.

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Time to appoint a new investment manager?

NICK SLADDEN of accountancy firm BAKER TILLY comments: For the trustees of charities with investment assets, it is fundamental that investment managers are proactive, knowledgeable about the charity’s plans, can establish excellent working relationships, communicate clearly with the board and, most importantly, provide a return on your charity’s money.

REVIEWING ADVISERS. As part of its business plan, a well run charity will have a date for a review of investment managers. The reviews may differ in approach, from a full beauty parade to a discussion at a trustees’ meeting as to whether the services are meeting the trustees’ expectations. Both approaches, and many others in between, are perfectly acceptable. However, it is important that an agreed process for service monitoring and performance measurement is in place.

The frequency of the review process will vary greatly from charity to charity, depending mostly on your relationship with your incumbent investment manager. If you are happy with the service and return being provided and believe the costs to be appropriate then why change? A tender process can be costly not only for the charity but also to the firms invited to tender. Therefore, the process should only be undertaken where there is a realistic possibility of a change. If it is only a few minor issues or niggles with the investment manager then an alternative solution may be to try and iron these out.

It is also good practice to schedule a review of your own agreed key performance indicators (KPIs) on a regular basis and involve your investment manager in this process. Investment managers and trustees should agree what these are and they should be benchmarked at least annually to specific criteria. KPIs should be qualitative as well as quantitative. For example, KPIs should cover accuracy and timeliness of information as well as simply benchmarking investment returns.

CHOOSING FIRMS TO INVITE TO TENDER. The following are important initial elements of the formal tender process:

• Discussions with colleagues in the sector.

• Reviewing accounts of charities similar to your own, noting who their advisers are (access to any charity’s accounts is free via the Charity Commission’s website). An advanced search also allows identification of charities with reference to their objects/activities/area of operation/income range in order to find those most akin to your own.

• Reviewing potential candidates’ websites. Do they have a section of the website that is devoted to charities? If possible, attend any events or seminars that they are running or other networking opportunities they may be supporting.

There is a happy medium for the number of firms invited to tender. Too many and the choice may become confusing; too few and there may be a lack of diversity amongst the managers.

ESTABLISHING THE TIMETABLE. Tendering should be a significant process and it is important that sufficient time is given to allow proper evaluation. The process should not be seen simply as one which should be undertaken to satisfy the requirements of "good governance".

Three months is a reasonable period to allow for the whole process. Firms should be given at least one month from the date of the invitation to tender (ITT) for submission of formal proposals. Consideration should be given as to whether you will be available for a scoping meeting. Although these can be viewed as time consuming, they can be particularly helpful in ensuring your requirements are clearly understood.

NICK SLADDEN of BAKER TILLY continues: At least two weeks should be given for evaluation of proposals and to establish a timetable for presentations by the short listed candidates. Formal presentations should allow time for a Q&A session. It is a good idea to set aside time to discuss all proposals soon after the presentations while all impressions and key points discussed are still fresh.

DECISION CRITERIA. It should be agreed at the outset what the decision criteria will be. This will produce a rational and transparent final choice. The following matters are relevant:

PRICE. Whilst cost is clearly important the decision should definitely come down to ‘value for money’ as opposed to lowest fees.

FEE PROPOSALS. These should also include the basis for future increases.

EXPERIENCE WITHIN THE SECTOR. Charity investment management is a specialist area and it is important to appoint advisers who understand the sector and its regulation. Information on the number of staff in their charity division and the links the investment manager has with major sector bodies such as CFG, NCVO etc can assist in assessing their commitment to the sector.

CULTURAL FIT. An initial assessment of cultural fit can be made from a review of the investment manager’s website and its proposal documents, but the key to reviewing this is how well you can see yourself working with the firm. Their attitude and responses at the presentation stage can provide a very useful insight into this. You should ensure that the team presenting the proposal would ultimately be the team dealing with your account.

REFERENCES. A list of current charity clients and requests for references should be part of the tender document, but consider whether the most revealing information/opinions might be obtained from clients of the investment manager’s whose details have not been provided.

THOUGHT PROCESSES. A useful way of assessing the time the firm has spent in preparation and to gain an insight into its thought processes is to ask what it thinks of your current investment portfolio.

SPECIFIC CRITERIA. Other charity specific criteria should also be added as any other items which are particularly important. Examples include: the proposed approach to handover from the incumbent investment manager; the location of the applicant firm; team continuity; speed of response; the impact of the firm at the scoping meeting; team spirit; the quality of the presentation.

AN INFORMED DECISION. The points above should enable the panel to make an informed decision about who to select but it is also worth noting that ‘gut feel’ should not be ignored. After all, the elements outlined above will provide the right process but it is the interpretation of the results that will ultimately count.

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Nick Sladden
Baker Tilly's Nick Sladden – schedule a review of your own agreed key performance indicators on a regular basis and involve your investment manager in the process.
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The investment adviser should have a good track record

MARK CUMMINS of advisory firm RUSSELL NEW comments: Selecting a firm to manage your investments is a process which shouldn't be taken lightly, after all it's important to be confident that the advisers chosen will have the charity's best interests at heart, understand your ethos and, most importantly of all, invest your money wisely in order to get the best return in accordance with your investment policy.

Perhaps the number one rule is to ensure that the investment adviser you are looking to use has a good track record, particularly working with other charities and that there is no bad publicity concerning them. In just the same way that you would ask for references before taking on new staff members, it's important to check the background, both of the advisers as a whole and any named individuals who would be looking after your funds, to ensure their credentials stack up. Most professional firms will supply a short list of clients who are willing to give a reference by telephone or in writing.

First things first though, draw up a short list of three or more firms to invite to tender and consider asking a third party, such as your accountants/ auditors to sit in on the presentations, as their impartial opinion will no doubt be helpful in the decision making process.

There are several pointers to look out for during any presentation, not least among them the language being used, as jargon and opaque language will not go down well with charity trustees and often merely means that the person doing the talking lacks knowledge of their subject. They are being appointed to manage significant funds and you therefore need to be confident that they will report to you in a clear, concise language which is understood by everyone.

MARK CUMMINS of RUSSELL NEW continues: The issue of language aside, any investment manager also needs to understand the ethos of your charity and should show a genuine interest in your work and your ethical stance. This way you can be confident that your funds will be invested wisely and in the best way possible while not in any way undermining your charity's aims. Obviously no financial investment is entirely without risk, but it is essential that any investment firm tasked with looking after your money understands your attitude to risk so that it doesn't end up in the wrong hands.

Once you've made your choice and selected the best investment firm to suit the needs of your charity, sit down with them and clarify your investment policy. Not only do they need to understand your needs and work towards them but any good adviser will also work with you to put an appropriate policy in place, so make sure you draw on their expertise. They should also be asking for a copy of your governing document to identify if there are any restrictions on the types of investments the charity can put its funds in to.

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Mark Cummins
Russell New's Mark Cummins – jargon and opaque language will not go down well with charity trustees and often means that the person doing the talking lacks knowledge of their subject.

Tasks for the investment committee

OLIVER BURNS of JUPITER ASSET MANAGEMENT comments: Selecting an investment manager can be one of the more difficult tasks for charity trustees. The process will cover many specialist subjects of which few trustees have extensive knowledge or experience. To help make the right decision, trustees can follow a few simple steps:

The first is for the charity to assemble a group of trustees to form an investment committee. Ideally, at least some of these individuals should have some financial experience. The investment committee need to be aware of the requirements of the Trustee Act 2000. Their key task is to decide on the key investment objectives for the charities' portfolio of investments and put together an Investment Policy Statement. This will help to clearly define what the charity wants from its investments, along with any specific requirements and time horizons.

The investment committee should put together a tender document and a long list of potential managers, preferably with differing investment styles. The identified managers should be sent the tender document and asked to complete a RFP – request for proposal – with the aim of inviting three or four of the companies to a 'beauty parade'. If the investment committee are unable or uncomfortable managing the selection process by themselves, they should consider employer an independent financial adviser or a consultant.

The beauty parade is the opportunity for the potential investment manager to sell their services to the trustees. In order to make a fair comparison, managers invited to present should have the same allotted time – around an hour is typical with some extra time for questions at the end.

Some of the issues to consider are: who will be managing the money and are they present at the meeting? A potential investment manager must demonstrate that they have clearly understood the objectives, have a realistic investment solution and some form of track record of success.

OLIVER BURNS of JUPITER continues: There will be some key differences between the investment approaches – is the manager proposing to invest directly in stocks and bonds or via collective investments such as funds, is it a bespoke solution or a single "off the shelf" fund? What differentiates one firm from another? Big is not always beautiful and many smaller investment managers are able to offer bespoke investment solutions for charities that are not available elsewhere.

Fees are the one area that trustees tend to agree on – the lower the better but cheapest does not always mean best. Unfortunately, investment management fees are rarely transparent and headline numbers can be confusing. Ask for the Total Expense Ratio (TER), which is a measure of all costs relating to the management of your portfolio. This should help you to understand what you are paying for. A genuinely bespoke management solution is likely to be more expensive than an off the shelf fund, however the focus should be on achieving the goals set out in the Investment Policy Statement.

Finally, personal relationships and service are important. Typically, charity mandates are given for many years and you need to consider whether you will be able to form a good relationship with your investment manager. Is the manager willing to meet trustees on a regular basis at a time and place to suit you – in good and bad times?

Choosing an investment manager is not a simple process, but the task can be made a great deal easier by investing some time and taking a structured approach to the selection process.

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Oliver Burns
Jupiter's Oliver Burns – the investment committee should put together a tender document and a long list of potential managers, preferably with differing investment styles.
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There's more to performance than financial return

RICHARD MACEY of M&G INVESTMENTS comments: Investment managers should provide performance and partnership, and the two are intertwined. Performance is about much more than giving you a financial return on your investment. It's about making sure you as a charity trustee feel absolutely confident in the partners you've chosen to help you meet the charity's investment aims. Your investment manager should adhere to three core principles: investment excellence; commitment to long term partnership; and conviction.

First, an investment manager's main objective is to ensure that your capital grows over time, in line with the charity's aims. So the fund manager should demonstrate their skill in making positive investment returns over the long term. But investment excellence isn't just proving you can shoot the lights out with high performing products. An investment manager should demonstrate original and independent thinking that has a proven track record. Bringing a new investment idea to market might be great, but does it really work in the long run? Has it delivered the intended results?

The investment manager should demonstrate that they have listened to you, fully understand what the charity's goals are – income generation or capital growth – and that they can offer you a choice of investments which will meet your specific requirements over many years.

Second, the investment manager should be open, available and responsive in order to build trust and partner with the charity for the long term. The investment manager should be utterly focused on doing what you ask of them, namely growing your capital over the long term. But you should see your investment managers and your adviser, if you have one, working seamlessly.

They should communicate regularly with your adviser and with you to ensure your investment requirements are continuously reassessed and your portfolio adjusted when the time is right. They should be efficient in responding to queries you might have. Charities' requirements can change over time and economic events can very suddenly create fresh challenges or fears for a charity trustee, so this level of dialogue is really important for the charity manager to understand what's going on and the potential impact on the investment portfolio.

RICHARD MACEY of M&G continues: Then there is the third principle, conviction. If you are talking to an investment manager which has been through several economic cycles with charity clients, you should bear in mind that sometimes it takes courage to stick to an investment approach that might be out of fashion. It's not always easy to pursue an investment opportunity when a particular style of investing might be out of favour, or to exit a given sector or market when all around are buying in.

Conviction only comes when the investment manager has freedom and flexibility to develop investment ideas that are cultivated using robust and repeatable research, portfolio construction and risk management processes. Over time, the results should speak for themselves.

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Richard Macey
M&G's Richard Macey – investment excellence isn't just proving you can shoot the lights out with high performing products.

There's a web of complexity to consider

TIM MAILE of investment firm QUILTER comments: Charity trustees will be required to make a number of important decisions, but probably hardest among these will be choosing the right investment manager. The Trustee Act 2000 places a duty of care on trustees to periodically review their investment management arrangements, so what key areas should they be looking at?

It is tempting just to look at fees and performance as these are probably the most visible comparisons, but scratch beneath the surface and trustees may find themselves caught up in a web of complexity.

Take the example of fees. A low headline rate may not take into account the annual management charges where third party funds are being used. Similarly, does it include other transactional charges such as commission or safe custody? These can add up and may not only have an impact on returns, but will ultimately leave the trustees with less spending power.

Similarly, performance is also not just about being at the top of the league table. The chances are that exceptionally strong results are unlikely to be repeatable on a year in year out basis. If trustees are being offered those sorts of return, they need to ask more questions about how they are being achieved and at what risk.

Most trustees would feel uncomfortable if these returns were being accompanied by higher levels of volatility, which then creates issues for financial planning. Whilst it is very difficult to diversify away the risks entirely, the best strategy for most charities is one which does not leave the trustees exposed to financial risk during periods of market volatility.

Investment managers should be able to explain their investment philosophy in a way that trustees can easily understand, and also demonstrate that they have an investment process which can weather all conditions. Markets are dynamic. The regions, sectors, stocks and investment styles that are performing shift constantly, so why should trustees restrict themselves to one particular style?

TIM MAILE of QUILTER continues: Managers need to show flexibility. For example, how do they react in periods of market stress? After all, many charities will have investment time horizons that extend well beyond the lives of the current trustees and will have the capacity to take advantage of pricing anomalies and other opportunities which are being presented.

Other issues such as the ownership structure, clarity of reporting and the ability to manage ethical mandates – an increasingly hot topic as socially responsible investing rises up the agenda – will also need to be considered. But ultimately, it is all about trust and having the confidence that the investment manager selected will be able to successfully execute the investment policy and enable the charity to fulfil its long term objectives.

However, for all the questions the trustees will be asking of their prospective investment manager, perhaps the most important one is of themselves. What is it that they are actually trying to achieve from their investments? It is only when they have established this and formulated a policy document that they are really in a position to start the selection process.

After all, to return to our opening point this will be one of the toughest and most time consuming decisions that the trustees will have to make, so why make it harder by not putting in the necessary groundwork?

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Tim Maile
Quilter's Tim Maile – the chances are that exceptionally strong results are unlikely to be repeatable on a year in year out basis.
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You have to do your homework

RICHARD NUNNELEY of investment firm DALTON STRATEGIC PARTNERSHIP comments: We have all read CC14 and thought long and hard about the pearls written on pages 21 et seq but what else do we need to know about appointing a new fund manager? Whatever the reason for a beauty parade trustees and their executive need to prepare very carefully. Use it as a root and branch review of the charity's objectives. Sadly a general consensus amongst a caucus of leading investment managers is that many charities convene beauty parades yet are unclear as to what it is that the chosen fund manager must produce. Why do you think the existing one has failed?

Key to this will be the attitude towards risk and long term expectations. Check the reputation of your candidates and ask your peer charities for thoughts. Embrace your accountants as a source for good. Is the portfolio to be managed on an absolute, total return or income basis? What do longer term cash flow projections indicate? What contingencies are required? Are trustees minded to seek a funded solution or a segregated one? Factor in ethical and socially responsible factors and one can see why Prior Planning Prevents Poor Performance.

REQUESTS FOR PROPOSALS. So having collected your thoughts send out a detailed RfP and test the candidates' ability and appetite to manage your charity. At the very least include the existing incumbent. From an initial long list you can then refine down to a short one buoyed by the fact that hopefully many of your questions have been resolved.

RISK APPETITE. The true appetite for risk is often not best understood by both sides. What one man sees as a risk represents an opportunity for another. Fail to interpret it correctly and disappointment will only follow, so take some time to get this right. Be prepared for one or even two follow up meeting.

From this should come the choice of an appropriate benchmark. Do not allow the fund managers to promise the world by suggesting an easy target which then translates into index tracking, closet or otherwise. Demand a benchmark which is realistic, demanding but achievable.

CHEMISTRY. Digging deeper, are you meeting the fund manager or his relationship manager. Are you being pushed into a one size fits all solution or a more bespoke one? Inevitably the size of your investable funds will probably dictate what seems the most cost effective. If you do not mind being a small fish in a large pond then you might compromise on the levels of service you get.

RICHARD NUNNELEY of DALTON continues: Generally though, unless your portfolio is worth more than £7m, a funded approach has its attractions – and may offer much easier administration – think of the reduced audit costs. For a greater sum a segregated solution can be fine tuned to match your desires but watch the costs. But do not be a snob. Some very large charities are content to invest in common investment funds so it is all about expectations and ultimately chemistry.

ADMINISTRATION. Look very carefully at the type and frequency of reporting documents. Ask for examples. Do they answer your questions? Are they flexible enough to factor in your specific wishes? Who are the custodians and bankers? Are your cash and assets ring fenced and if so by whom?

FEES. Fees are often a vexed subject. Like all things, negotiate. If you are offered a funded approach or a segregated one by the same people seek a discount. Needless to say, if the fund manager delivers what you want then all is fine but if not…! However, assistance comes in many forms so investigate outside the box. Do they run free seminars for clients? How helpful are their newsletters? Do they save you from outsourcing for additional advice?

CONCLUSION. A great deal of work but it has to be done.

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Richard Nunneley
Dalton Strategic Partnership's Richard Nunneley – trustees should be encouraged to develop the absolute return discussion with fund managers and at least examine their place or otherwise in a portfolio.
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Start by defining what you are looking for

CHARLES MACKINNON of THURLEIGH INVESTMENT MANAGERS comments: If you are thinking of choosing a new manager, the first thing you, as a committee, need to do is to define quite clearly what you are looking for. Are you looking for a manager to fill a "slot" that has been defined by a consultant (e.g. US equities)? Or are you looking for a manager to complement or compete with existing managers?

Once you have defined what you are looking for, perhaps with the help of external consultants, you can then write a brief which can be submitted to a long list of potentials.

As the chairman of the investment committee of two charities and as the investment manager for half a dozen, (no doubt like some of the other participants in this discussion) I sit on both sides of the table sometimes in a single day.

As the submissions come in, the first "cull" is to remove any proposal that does not answer the questions raised in the brief. It never ceases to astonish me (as a trustee) how many large institutions simply send a boiler plate pitch book without any attempt to relate it to your specific brief. These should be disposed of immediately.

As a manager, it never ceases to astonish me how many invitations to pitch come where it seems that the charity has divergent aims. This is fine if they are asking for general advice on the way to think about things, but that is very different from an investment proposal.

Also speaking as a manager of a small firm (£300m) it is also intensely frustrating to be invited to submit a proposal, and in some cases to attend a pitch, only to be told that we are "too small". As a trustee, you need to make sure that everyone you are contacting is willing and able to take the mandate, and also that you are willing and able to award the mandate.

The next step in the selection process is the beauty parade. In my mind, this should be a maximum of four participants: 45 minutes each with 15 minutes in between to write notes – and no lunch break. Either start early in the morning or directly after lunch.

Key things I look for (as a trustee) are:

• Have they read the brief?

• Do they know what we do as a charity?

• Is the person presenting the person we will be dealing with, and does he/she understand the solution he/she is proposing?

Key things I look for (as a manager) are:

• Does the committee know what it wants or is it looking for guidance?

• Are the aims and aspirations achievable or unrealistic?

• Who am I, as manager, going to be dealing with on a day to day basis?

• Are they interested or am I just a "filler" as they have made their choice and the whole exercise is a charade?

CHARLES MACKINNON of THURLEIGH continues: The astute reader will have noticed that at no point have I suggested that performance should be considered as a defining feature. For me as a trustee, it is only after we have found a manager that we are comfortable with that the question of performance starts to define who we should choose. Process and admin are far more important than short term performance.

With regard to performance, I think it is essential that trustees only look at metrics which they can understand. There is a large part of the industry which seeks to define risk and performance, but much of their "results" are incomprehensible. Do not get lost in complex statistics! Also, if there is a team or individual who you feel comfortable with, and their performance is a small bit behind someone with whom you don't, give the mandate to him/her as the future is always uncertain.

Last but not least, aim to allocate money for at least three years and tell the manager this is your intention. That way, they will get on with their job and not focus on monthly numbers.

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Charles MacKinnon
Thurleigh's Charles MacKinnon – as the submissions come in, remove any proposal that does not answer the questions raised in the brief.
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When you have to ask about responsible investment

RUBY SANDHU of law firm AMSTERDAM & PEROFF comments: If the charity believes in an environmental, social and governance (ESG) policy or responsible investment policy, one would envisage this to be a clearly defined commitment in its statement of investment policy, available for review on a regular basis by the board of trustees and the fund manager. On that basis one would expect certain criteria to be met by any fund manager in a selection process for a new investment mandate.

You really do need to make sure that the fund manager is aware of or, where appropriate, is actually a signatory of various internationals norms and/or standards, e.g. from the UN. You need to be clear about the fund manager's investment philosophy and strategy and with respect to ESG. You need to know about the fund manager's ability to incorporate ethical and ESG factors into an investment policy. Question the relevant expertise in this area.

You need to be comfortable about the fund manager's transparency and openness in relation to making such investments, the process and internal system checks to ensure compliance with an ESG policy. You should know what is the fund manager's definition of perceived/potential risks with respect to such investments and the quantitative approach taken to risk around ethical screening and ESG. You should ask what is the fund manager's methodology and regularity for reporting, and the provision for adequate monitoring systems to ensure implementation of the responsible investment policy.

Then there is the importance of the general relationship and openness in communication between the trustees and the fund manager, with respect to ensuring that the defined mission objectives and responsible investment policy are constantly under review so as to ensure implementation. Generally ascertain the ability and interest in collaborating with other entities and stakeholders to address economic social governance issues and challenges.

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Ruby Sandhu
Amsterdam & Peroff's Ruby Sandhu – you need to be comfortable about the fund manager's transparency and openness in relation to making responsible investments

Questions you should be asking yourself

HELEN BESANT-ROBERTS of accountancy firm HURST comments: Do you want a fully outsourced discretionary portfolio management service or just an advisory service? In either event, it would be wise to undertake a tendering process to select the most appropriate investment manager using the following criteria.

Does the candidate have:

1. Ability to deliver the charity's investment policy and suitability of investments?

2. Experience and understanding of the sector?

3. A past performance track record and expected performance returns?

4. Appropriate experience for the charity's size, purpose and location – the large London-based investment houses are not necessarily best suited for this task?

5. Flexibility to tailor their offering – one size does not fit all?

6. An approach that fits with yours?

7. The ability to transfer investments quickly?

8. Fair fees and charges?

9. Managers who you can get along with?

10. Staff continuity?

11. Proof that they can add value to your investments?

12. A reputation for service excellence?

13. Clear reporting, reviewing and monitoring arrangements?

14. References?

15. Independence and impartiality?

Your professional advisers may well be in a position to help you select the best investment management option and ensure appropriate written contracts are put in place once selection has been made. And finally, remember that, in law, trustees cannot delegate their overall duty of care towards they charity they serve. In the ultimate analysis, they are responsible for the use (or misuse) of the charity's money.

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Helen Besant-Roberts
Hurst's Helen Besant Roberts – a one size investment management offering does not fit all.

You want to get the most out of the process

HEATHER LAMONT of investment firm CCLA comments: Running an investment review is going to take up a fair bit of your time, so you want to get the most out of it. It's an ideal opportunity to get some free consultancy from different managers, bring yourself up to speed on investment thinking and refresh your investment policy.

To do that, you need to stay focused on the high level objectives for the portfolio – what are the investments there for? – and encourage managers to present their ideas on how those objectives can best be achieved – what investments should you hold and how should they be managed?

If you already have a written investment policy, managers will want to see that, but do invite them to comment on it. They should have views on whether your objectives are realistic (or, conversely, under-ambitious) within a suitable risk framework, and may well be able to identify opportunities you haven't looked at before.

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Heather Lamont
CCLA's Heather Lamont – you need to stay focused on the high level objectives for the portfolio.

Exercising a broader due diligence for charity investment

Consciously ethical investment may not be a policy which all charities wish to specifically pursue – and here we are talking about equity or social investment – but one would argue that increasingly charities will have to take on board that investment by them does require some sort of screening of companies in a portfolio to avoid, at the very lea st, controversy arising in the future. Charities which invest in companies cannot escape the burden of ensuring that a company is compliant with important business codes and is not linked to breaches of such codes.

This is particularly the case when companies are based overseas or have overseas operations, the risk being necessarily greater in certain areas. There is also a general atmosphere of heightened public and political sensitivity about non-investment matters which can have added relevance for charities when making or holding investments.

The current proliferation of principles and guidelines addressing issues of business compliance in the global marketplace is making life harder for charity investors, including those which accept they have to keep a watchful eye on the way guidelines are being developed all the time for corporate behaviour – and how the companies they invest in adhere to them. These guidelines include the United Nations Protect, Respect and Remedy Framework for Business and Human Rights, and the Private Equity Council Guidelines for Responsible Investment. Then there is the Charity Commission's CC14 – Charities and Investment Matters: a Guide for Trustees – which is a set of guidelines within a legal framework.

Incorporating core principles

As we are all well aware, guidelines are not hard law and are therefore not enforceable in a court of law. However, any responsible charity investment policy requires incorporation of the core principles provided in such guidelines and importantly an awareness of the guidelines' development and implementation.

The awareness, incorporation and implementation of these guidelines become relevant for charities not only because of the Charity Commission's CC14 guidelines, but also where an inadvertent investment in a portfolio with an element of high risk – involving, for instance, a business supply chain in an emerging and/or frontier market – could trigger the impact of other guidelines.

A case in point is the UN Human Rights Council's adoption in June 2011 of the Protect, Respect and Remedy guidelines. The PRR guidelines were created to redress the failure of state and non-state entities to provide the appropriate institutional and investment framework for ensuring that business violations of human rights and the environment did not take place on such a flagrant scale. These violations were brought to the court of public opinion by impassioned stakeholders and NGOs. This was compounded by the intensified social media and the speed and medium with which information could be disseminated.

Suffering reputational damage

An investment under the guise of "business as usual" in an emerging/frontier market could suddenly find itself subject to reputational damage and/or political risk. Trustees have a duty to further the purpose of a charity's objective, while ensuring a best return on investments within a defined level of risk. Due diligence is therefore required in the screening of investments, including mixed motive and programme related investments, to ensure these developments are incorporated into a charity's investment policy to avoid reputational damage or political risk.

However, there are no specific parameters to define the incorporation of guidelines (unless specifically directed to a legal obligation within the guidelines) in relation to a charity's investment objectives. It then begs the question as to exactly how intensive the due diligence needs to be and how it should be conducted? There is unfortunately no size that fits all. However, account must be taken of the current wave of unrest and change, and in social patterns, with a clear undercurrent for building values based on ESG (environmental, social and governance principles), transparency, responsibility and accountability.

Triple bottom line investing

"Triple bottom line investing" (TBLI) is one example of an attempt to provide a solution to the unrest without impacting profitability. That is, creating structures with an ethical investment, appropriate social impact and successful generation of profits for the stakeholder. However, funds investing in companies with a compliance based due diligence, linked to perceived responsibilities, and built on "green washing" (misleadingly proclaiming rather than actually doing) will not be enough to ameliorate the unrest and avoid inadvertent risk.

The dynamic and emerging reality based on an emotive mix of ethics, morals, values and fairness – concepts which in themselves are hard to define or specifically legalise – are at least providing a basis for the emerging principles and guidelines.

A due diligence framework which incorporates these values therefore requires a genuine attempt at an assessment of activities of the fund, an understanding of the investment relationship in their social, political, and economic context, along with the charity's investment mission, ethical criteria and standards.

The scope of due diligence

However, the parameters are wide and there is the emergence at the very best of norms. As such due diligence extends beyond an investment's own activities to include relationships with business partners, suppliers and other non-state and state entities which are associated in the investment activities' supply chain. A failure to take into account these considerations could result in a charity facing a claim for negligence.

In addition, such a due diligence process would need to be a continuing and evolving one. Appropriate systems would need to be devised and implemented which take action on the empirical information received from such due diligence and with the appropriate reporting requirements.

As the due diligence system matures, the lack of enforceability of these principles can be balanced by providing for the appropriate grievance mechanism in the investment. Such a grievance mechanism ensures that where there is a real/perceived violation, the initial failure to redress the wrong does not escalate into a situation which proves to be costly, unnecessary and a reputational threat to the investment.

Vital role of stakeholder activism

Stakeholders, including charities, play a vital role in addressing the compliance of investments with these emerging and evolving guidelines by this form of stakeholder activism. This stakeholder activism ensures that they are not complicit in human rights or environmental violations. The criteria that charities should take into account are the importance placed by an investment on its transparency, internal systems and procedures, openness and awareness of the vulnerability of attacks from other active stakeholders.

An investment which takes a proactive stance in incorporating and operationalising values and ethics is critically necessary and not just advantageous. A management which is willing to educate, is aware of developments and is subsequently reviewing is internal systems in line with a multi- stakeholder approach to address concerns at an early stage is clearly beneficial.

These emerging guidelines and principles may appear to be onerous obligations, but with today's viral and sophisticated social media and speed of communication, they are the essential infrastructure required for enhanced due diligence and a charity's adherence to an evolving set of model principles.

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Ruby Sandhu
Amsterdam & Perloff's Ruby Sandhu – the due diligence process required of charity investors would need to be a continuing and evolving one.
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Explaining absolute return investment

Explaining absolute return investment

NICK HORTON of Dalton Strategic Partnership explains: Historically charities have allocated assets to balanced mandates, which invested in equities, bonds and property with the objective of outperforming an equity/bond composite benchmark. Since 2005 there has been an increase in demand for absolute return type products from charities.

The term absolute return encompasses a wide range of strategies. The common link is that they all aim to achieve a return above a cash benchmark (absolute return) rather than a relative return above a particular equity or bond benchmark. Both hedge funds and multi-asset/absolute return funds are considered absolute return strategies as they aim to outperform a cash benchmark. However, they differ in a number of ways:

HEDGE FUNDS. They are able to invest on a long and short basis and can use leverage to alter market exposure. In relation to fees, they typically charge a 1%-2% annual management charge, and a performance fee of 20% of the fund’s outperformance.

They have sub-groups. There are many different types of hedge fund strategies (e.g. market neutral, long/short equity, global macro), each aiming to produce a positive return form a different skill set.

ABSOLUTE RETURN FUNDS. These have the flexibility to invest in a range of asset classes (equities, bonds and alternatives, e.g. commodities, infrastructure, currencies). However, unlike hedge funds they will typically invest on a long only basis and as a consequence will be more directional than hedge funds. In addition, unlike hedge funds, absolute return funds will typically not use leverage (borrow to enhance returns).

In relation to fees, they typically charge a standard annual management charge, which varies from 0.5% -1% depending on the underlying vehicles used to access each asset class.

There are sub-groups. These all aim to deliver typically LIBOR +5% over a market cycle and the universe can be divided into capital preservation and diversified growth funds. Capital preservation funds have broad flexibility to tactically asset allocate between asset classes, and can hold a significant proportion of assets in cash. Diversified growth funds have a broad strategic exposure to a range of asset classes and are less active in their tactical asset allocation.

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Active fixed income investing for charities

Bond markets have developed significantly over the past few decades and there are many types of bonds in issuance, offering charity investors considerable flexibility over their investment choices. Experienced investors have now also become accustomed to the idea of being able to enhance portfolio returns through the active management of bonds within portfolios.

Specialist bond investment managers may use the qualities inherent in various types of bonds to tailor the exposure of portfolios to an investor’s specific risk and return requirements, while also augmenting returns through active management. This can indeed be particularly useful for charities, which no doubt may have to balance short term investment requirements against longer term aspirations.

Bonds offer charity investors a variety of attractive qualities including the delivery of a regular income, the relative preservation of capital, portfolio diversification and potentially they can also act as a good hedge against an economic slowdown. Depending on tolerance for risk and investment objectives, various bond investment strategies can be advanced which can enhance income and diversify risk for charities.

GOVERNMENT AND CORPORATE BONDS. Two of the most liquid areas of bond investment are those of government and corporate bonds. Bonds aren’t typically held to maturity by most investors, and can be traded in secondary markets, where their price will be determined by factors such as interest rate expectations, term to maturity and default risk. Inflation risk may also be hedged through inflation linked varieties of such bonds.

Global corporate bonds

Through investment in global corporate bond issues, from investment grade to higher yield, an investor may benefit from a reasonable increase in yield relative to government bonds and cash. Corporate bonds fall into two broad categories: investment grade and sub investment grade (or high yield) bonds. Investment grade corporate bonds, where the financial health of the issuer is generally much stronger than for the high yield issuer, have become increasingly attractive in an environment in which gilt yields have moved to record low levels.

SO WHAT DOES THIS MEAN FOR CHARITIES? Charity portfolios are likely to be best suited to a diversified bond investment strategy, managed by a specialist bond manager. This strategy should aim to preserve capital, while producing a reasonable level of income and an active enhancement of return by moving the portfolio between bond sectors according to expectations of economic trends. There are several key strategies which can be employed to add value through an active approach to investing in bond markets. These include duration, credit and yield curve management.

Duration management

Duration management involves the adjustment of holdings within a bond portfolio, to benefit from the bond manager’s expectation of interest rate movements. If interest rates are expected to fall, then an active manager can lengthen duration of the portfolio, by selling shorter dated bonds and buying longer dated bonds. The portfolio will be expected to benefit from the price appreciation of a decline in interest rates. In anticipation of rate increases, the duration may be reduced through selling longer term bonds – the value of a shorter duration portfolio should fall less than a longer duration portfolio should rates rise as expected.

CREDIT QUALITY. Another active strategy which a bond manager can employ is adjusting a portfolio’s credit quality. Corporate bond issuers can generally be expected to experience improvement in their credit fundamentals when the growth of their economies is improving rapidly. An active bond manager can use their knowledge of credit analysis to identify credit sectors which are likely to benefit most, hence potentially enhancing the portfolio’s return. Lower credit quality bonds would tend to outperform in periods of accelerating growth, while the highest credit quality bonds would tend to perform better when growth decelerates.

YIELD CURVE. Yield curve management is another often employed strategy for adding value by active bond managers. The yield curve shows the relationship between similar bonds of different maturities. It is generally upward sloping, with longer dated bonds providing additional compensation in the form of yields to investors, relative to shorter dated bonds.

A changing situation

This relationship can change however, as the economic environment adjusts for interest rate changes and inflation expectations, and also due to supply/demand dynamics. An active manager may position a bond portfolio in the areas of the yield curve that will benefit the portfolio the most for certain economic environments.

LESS RISK THAN EQUITIES. A charity looking for income or capital and income growth with less risk than equities should allocate a reasonable amount of their overall assets to active fixed income investment, particularly in uncertain times as such an investment can offer an attractive and more stable income stream than many asset classes.

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Craig Veysey
Principal's Craig Veysey – there are several key strategies which can be employed to add value through an active approach to investing in bond markets.
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