Is your manager measuring up?
The Conundrum - Once upon a time, investors appointed fund managers to make them money. Life was simple: clients expected a return better than they could achieve from leaving cash on deposit.
While a few stock market indices had existed for many years (the Dow Jones Industrial Average Index has been calculated since 1896), the modern and diversified market capitalisation based indices we follow today came into being in the 1960s: the FTSE All Share Index was first calculated in 1962, while the MSCI World Index and TOPIX index in Japan were born in 1969.
Stockmarket indices allowed investors to track the health of the market which in turn, meant they could gauge how their fund manager had performed versus a benchmark: were they making enough money and were the fees and commissions they were paying for active management worthwhile?
Matters started to become serious in the 1980s: despite the calamitous markets of the 1970s, by the mid ‘80s, just ‘making money’ seemed too easy a target to give a fund manager. Everyone was making money and the more sophisticated investors not only compared individual elements of their portfolios to the most relevant index (UK Equities against the FTSE All Share Index for example), but also combined indices of different asset classes in fixed proportions to measure the performance of multi asset portfolios.
The rise of these bespoke, index-based benchmarks allowed increasingly accurate attribution data to be collected, so that specialist consultants and investors could see to within a fraction of a percent where their fund manager might or might not have added value.
But many investors wanted more information and clarity about the measurement of their portfolios. They were struggling to understand what the benchmark actually meant. And what if their benchmark was wrong? What if other investors were following better strategies? Even if they had outperformed their benchmark, what if other investors had made even more money? Was their benchmark too easy to beat? Hence at much the same time as the rise of the index-based benchmark, the ‘peer group’ benchmark was born. In the charity world, the WM Universe was first calculated.
By the early 2000s, the bewildering variety of ways that one could measure the success of one’s investments resulted in both professional fund managers and their clients becoming mildly bewildered as to what they were trying to achieve, and whether they had performed well or badly!
Moreover, the benchmark-driven competition and awareness of what everyone else was up to within the fund management industry led to some unforeseen consequences, like closet index-tracking and the ‘hugging’ of peer group benchmarks. At one point, UK pension fund managers were falling over themselves to have less invested in America than each other, with everyone thinking (incorrectly) that the market was over-priced and likely to fall.
During the course of 1990s, as markets rose and rose, allocation to equities steadily increased: it was almost impossible to outperform if you didn’t have at least as much in equities as the competition. As a result, by the end of 1999, the average charity had 85% allocated to equities, up from 70% in 1986. And then markets collapsed.
Unsurprisingly, there was much head scratching in the early 2000s. Since the bottom of the dotcom-inspired crash in 2003, we have seen a return of the ‘just make me money’ mentality, albeit with specific amounts of return forming part of the objective. We have witnessed the rise of the ‘target return’ mandate, often carrying something like an ‘inflation plus 4%’ benchmark, with the caveat of it being achieved over rolling 5-year time frames. This is designed to act as a spur for the fund manager not to let the portfolio suffer too badly in a bear market.
Since the mid-2000s, this absolute return approach has gained significant traction, not just in the charity world, but as a distinct allocation within billion dollar pension schemes and across the retail market place, where a range of real return, target return, diversified growth, multi asset and absolute return funds now vie for investors’ attention.
Despite subtly different names, they are all trying to achieve much the same thing. However, the ugly markets of 2008 and 2011 proved just how hard it is to achieve attractive returns when equities and most of the higher return assets like property, corporate bonds and many alternatives all fall in value at the same time. With only government bonds providing a safe haven, many of these absolute return approaches have now disappointed investors.
Indeed, since 2008, many have been over-cautious and have significantly underperformed strategies less concerned about avoiding short-term and short-lived drawdowns. Consequently, many investors who switched into lower volatility strategies in early 2009 after the shock of 2008 are already wondering whether these new multi asset strategies are really how their assets should be managed.
So, how should sophisticated long-term investors measure the success of their investment programmes? What is the ‘right’ strategy? What can we learn from past mistakes and the large amounts of data that has been collected over the years?
While there is nothing fundamentally wrong with any of the approaches outlined above, all have ultimately proved flawed in some way or other, either because of prevailing market conditions or because they lead to unanticipated fund manager or client reactions.
We would suggest trustees adopt the following three-pronged approach:
• First, we would advocate adopting more than one measure, while ensuring that there is a clear ‘hierarchy’ as to which is the most important, the timeframes over which each should be considered and the likelihood of their being achieved. All of these need to be set in the context of the charity’s wider objectives: investment portfolios are simply one tool that can be used to help a charity achieve its goals.
• Second, we suggest trustees don’t just focus on total returns: for many charities, significant value can be added by tracking income and capital returns independently.
• Third, measuring the softer elements of ‘success’ is important. Poor administration, weak reporting, constantly changing personnel or altered service levels can all lead to trustees losing faith in a manager or investment strategy, against a backdrop of otherwise acceptable performance. While there are moments when any of these should result in a shift in strategy or manager, sometimes a word in the right ear can lead to an improvement or change in personnel, negating the need for any more dramatic and potentially costly actions.
How to measure performance
Before concluding, I would like to add some detail to the first of these points. What are appropriate measures and how can they be made to work together, to ensure good long-term results are achieved?
The investment strategy is key and can be designed by trustees and charity executives – quite possibly in conjunction with their fund manager and/or consultant.
This strategy, if invested in a passive manner, should stand a reasonable chance of being successful. By ‘being successful’ we mean that the mix of assets, their liquidity, risk and return profiles and ESG credentials match as closely as possibly the charity’s known short to medium term cash requirement, longer term liabilities and reputational needs.
Assets and investment styles need to be blended together in such a way that while success cannot be guaranteed, it is also not solely predicated on trustees picking an unusually clever fund manager. In designing the overall strategy, the aim is to ensure that the charity is never a forced seller of illiquid assets at inopportune moments. As a result, for many operating charities or those with lumpy expenditure, some ring-fenced allocation to low return, but safe assets may well be necessary.
Many trustees choose to divide their assets up into short, medium and long-term ‘pots’. This allows different portfolios to be built to meet specific liability and return goals. Each portfolio can then be given an appropriate absolute return target, an appropriate index-based benchmark, and – in some cases – the results can be compared to other portfolios being managed in a similar manner.
This is effectively the hierarchy of benchmarks. Of primary importance is making enough money so that the charity can pursue and achieve its objectives. However, with longer term monies, it could be entirely appropriate that a target return of CPI +4% is measured over 5-7 year timeframes. This is where the secondary index-based bespoke benchmark comes into play. It allows trustees to review the tactical skills of their fund manager over shorter timeframes to see where they have (or have not) added value. Lastly, if the strategy is mainstream, trustees might chose to look at how a peer group of other similar investors have done. This final measure can be a helpful way of seeing whether the combination of strategy and tactics has worked. In the charity world, this probably means looking at the ARC series of peer group returns. With the closure of the WM Company in March 2016, Asset Risk Consultants are currently the sole independent measurer of charity investment performance.
Finally, it is worth noting that the best long-term results have been achieved by investors (and fund managers!) who not only know that they will be disappointed at times, but are also cognisant of the conditions which are likely to lead to such disappointment.
When results are poor, they seek to understand how and why any under or over performance has been achieved. Understanding performance is an absolutely critical element in making good decisions and not switching strategy, style or fund manager at the wrong moment. Holding one’s nerve after a bad period can be one of the best decisions one makes – and really brave investors sell at the top, be it a security, asset class…or fund manager!
Being whipsawed between different investment styles just ahead of an inflection point in markets is a sure fire way to lock in bad historic results. And, it can bring about further bad performance as the new manager’s recently successful approach runs out of steam.
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Richard Maitland is a partner and Head of Charities at Sarasin and Partners.
Richard has more than 22 years of investment experience and joined Sarasin & Partners in 1992. In addition to UK equity research, Richard has led the firm’s third party funds research team, analysing specialist equity funds and alternative assets while managing portfolios for a range of charities, pension funds and unit trusts. He now focuses on managing diversified multi-asset portfolios for charities and assists in setting the firm's long-term strategic asset allocation. He is author of the Sarasin & Partners Compendium of Investment. Richard has a degree from Newcastle University and is a member of the St Paul’s Cathedral Investments Committee. He has been a visiting lecturer on investment and endowment management at the Judge Business School and the Universities of Stellenbosch and Vienna.Read more articles by this author