A flick of the switch
Richard Maitland argues that attitudes to investment styles and asset choices need to be flexible and not entrenched.
Light switches used to simply flick on or off, but many now operate on dimmers. One can choose between darkness, light or somewhere in between: is the same true of investment?
While there are some things in life that are absolute – it’s quite hard to be ‘a little bit dead’ or ‘half pregnant’, in most matters, decisions are not so black and white. Investment is a subject where one needs to be flexible: it is rarely correct to adhere slavishly to one particular style or to dismiss an asset class altogether.
However, as it allows for clarity when marketing and differentiation against competitors, investment managers will often build businesses around a particular style of investment, shouting loudly that this is the only and best way to proceed. Sometimes they are right – but it is this author’s belief that in most instances, such extreme conviction is rarely right for the client.
This article examines five areas where investment managers have tried to draw clear distinctions between one approach or another – ‘you must do it this way or that way’ – when in reality, something in between might be best. It considers some of the asset classes and tools that trustees have historically felt they need to give clear ‘yes or no’ instructions, when allowing one’s fund manager a little tolerance might be the best course of action.
Total return v income
For charities that are not permanently endowed and where trustees can consider spending capital as well as income, we think that portfolios at either end of the yield spectrum are unlikely to do consistently well over the longer term.
We would support the view that UK charities can afford to spend about 4 per cent to 4.5 per cent per annum, while maintaining the ‘real’ value of their capital over the longer term: effectively balancing the needs of today’s beneficiaries with tomorrow’s. However, designing a portfolio that yields an income stream of more than 4 per cent in today’s market is fraught with danger and can skew a portfolio towards UK assets, lower growth businesses and away from some interesting opportunities overseas and from some of the lower/zero yielding asset classes.
That said, we feel equally uncomfortable with portfolios that yield less than 2.5 per cent when a client is looking to spend more than 4 per cent. The experience of many US endowment funds with their significant exposure to illiquid, low/zero yielding assets classes such as hedge funds and private equity was that at a time of stress, one simply could not extract capital to spend, or at least not without having to realise significant losses at a really inopportune moment.
In our opinion, a charity’s approach to its withdrawals policy is a classic case of the middle ground being the safest and best place to be. While we recommend trustees embrace the concept of total return investing, allowing us to invest in the full range of asset classes in a global manner, we are not ‘agnostic’ about income. We see no reason why a modern, well-diversified portfolio cannot sustainably yield about 3.5 per cent and feel uncomfortable when income makes up less than 70 per cent of a withdrawals programme.
To us, this seems a prudent approach that acknowledges the presence of a wider opportunity set than was the case 15 or 20 years ago. It also tackles the risks associated with income concentration in the UK equity market, while valuing tangible and sustainable income rather more highly than the ‘promise’ of capital appreciation.
Absolute return v relative return (or indeed target return)
No sensible long-term investor starts out to manage money on a relative return basis: all portfolios should be structured (after fundamental analysis) on the basis that they will provide a given level of absolute return.
However, while some investment managers expect to ride out significant volatility along the way, others seek to achieve absolute returns on a rolling 12-month or perhaps three-year basis.
If there was proof that attractive long-term returns could be achieved with very low volatility, then everyone would manage money on that basis. Sadly, this is an Elysian dream: no single asset class or static mix of asset classes can deliver such a promise. Significant manager intervention and active management is required to try and avoid the draw downs while benefitting from rising markets.
While there are a few investment managers who have achieved their target of providing consistently positive short-term returns and competitive long-term returns too, the investment world is littered with the majority of investors who have failed in their attempts.
Risk never disappears – it generally shifts from one place to another.1 Trustees appointing absolute return managers are generally swapping market risk for manager risk. As an aside, it is crucial that charities following an absolute return approach are able to hold their nerve, but at a different point in the stock market cycle to conventional investors. While they are likely to be happy if their performance is different to the majority during a bear market, it is crucial that they continue to back their manager if the approach fails to match peer group returns during better times, which might go on for several years. Switching between managers with very different styles on performance grounds is a very high-risk strategy.
In our experience, once again, an approach that adopts elements of both styles is likely to achieve the best and most transparent mix between market and manager risk and return. Mandates should be structured with a clear absolute target return objective and the fund manager should be able to show how this is going to be achieved and over what time period success is likely.
Such a portfolio will almost certainly include an allocation to short-term, absolute return strategies and funds where performance is more manager-driven than market driven. Indeed, some trustees might choose to allocate a small part of their portfolio to a specialist manager following such a strategy themselves. We would also suggest that the better conventional managers now ask for slightly wider asset allocation bandwidth than they used to, acknowledging that most trustees would really like them to at least try and avoid significant capital losses.
The other important consideration is that trustees should also question the degree to which they actually need to try and manage volatility. Typically, absolute return styles of investment cost clients a lot more than conventional approaches. Is the City selling ‘low-vol’ strategies because they can make more money this way, or because they genuinely believe it is a better approach?
Specifically, for a charity with a long-term outlook, with most of their expenditure met through income, do they really need to pay for short-term volatility management if a) they don’t need it and b) there is significant risk that the manager actually fails to deliver?
Derivatives, hedge funds and other complex investments
There was a time when even mentioning derivatives in front of trustees was pretty much guaranteed to cause distress, mistrust and probable loss of the account! Even now, with headlines about derivatives being ‘toxic weapons of mass wealth destruction’ many trustees favour a blanket ban on their use. In the same vein, strategies followed by hedge funds can be very opaque and hard to understand and most structured products need to be researched with a wet towel around the head and a large pot of coffee if their risks are to be truly understood.
It is unsurprising that many trustees simply ban the use of any ‘complex and higher risk investments’.
There are certainly derivative practices that we would frown upon in the context of charity portfolios and hedge fund tactics that we are uncomfortable with. When it comes to structured products, we have found that avoidance is usually the best strategy! Occasionally we are shown charity portfolios that have huge allocations to such investments and we are usually being asked to comment on them because of how badly they have performed.
On the other hand, there are some hedge funds that make great investments and subtle use of simple option strategies can enhance income and total returns. Even bespoke structured products, if the risks are understood, can make sense. While all these things add to the complexity of a portfolio, we suggest that understanding them is no harder than getting to grips with the balance sheet of the average FTSE 100 company, something trustees expect their investment managers to do all the time. So, just as trustees give their investment managers discretion to invest in the shares of some very complex companies and corporate bonds, the ability to allocate small amounts to alternative assets at the periphery of a portfolio makes sense too – perhaps up to 15 per cent?
Index tracking v active management
While Sarasin & Partners has a reputation for being amongst the more active managers and stock pickers in the City,2 we certainly make use of index trackers from time to time and understand their appeal to trustees, particularly those who have been ‘burned’ by a bad experience with a poor active manager.
There will always be a market for active and passive management and the ‘core-satellite’ approach, where a charity retains a cheap index-tracking core and a smaller more expensive actively managed satellite fund, is not without merit.
Two words of caution here though. Firstly, some index trackers and modern ETFs (exchange traded funds3) are rather more expensive than might be expected: trustees using them will need to explore the full costs of using them. Secondly, I have some concerns about investment managers adding value solely through active asset allocation, while using passive equity and bond funds. This seems to go against research and experience. Indeed, it is interesting to note that much of the pension fund consultant community has stopped seeking successful purveyors of tactical asset allocation, while continuing the search for successful stock pickers. Worse, excellent academic work showing the importance of asset allocation in explaining total returns has occasionally been used to support tactical asset allocation strategies – not something the research necessarily proves.
Multi-manager v single manager
Conceptually, a multi-manager approach makes perfect sense: no one investment house is brilliant at everything, so why not cherry-pick the best bits and bolt them together to create the ultimate multi asset portfolio? As a former analyst of third-party funds, I for one have always found this approach very appealing.
However, in reality, there are problems with such an approach, involving costs, transparency and actual results achieved. It would appear that the impact of double-charging (paying both the picker of funds and all the underlying fund managers) combined with the difficulty of picking fund managers who consistently outperform, has resulted in pretty dull returns.
Intuitively, the concept is so appealing that if it worked, then the majority of the City would be operating on this basis. The fact that there are relatively few offerings of this type for trustees to consider would suggest that the performance records of those that have tried haven’t stood the test of time and haven’t been good enough to win new business and spawn copycat competitors.
But that is not to say that managers and trustees should invest every penny with a single manager – far from it. Once again, the best results seem to have been achieved by managers who operate a degree of open architecture, balancing what they do best with a small selection of specialist and externally-managed funds. This ensures that costs are kept to a minimum (even if they are unseen by trustees, these costs impact performance and income detrimentally) while the portfolio benefits from a range of talent.
Heavy use of retail-oriented unit trusts also brings problems for trustees with ethical investment policies: while their UK equities and government bonds might comply, one effectively drives a coach and horses through the agreed strategy if the rest of the portfolio is invested in non-compliant third-party funds.
Caveat lector
While investment managers need to believe in something and have a clear philosophy about how they intend to make their clients money, it is rare that extreme strategy or style bias gets the best results consistently.
Of course there will always be examples of good results from one style over another, from an individual asset class or from a particularly brilliant fund manager. While the grass might well seem to be greener elsewhere, chasing last year’s fashion or best manager is rarely a good idea and one might need to wait a very long time until it proves successful again.
Ultimately, there are very few black and white answers in investment management and while adopting a little bit of everything can be hard to explain, for charities, it is probably not only the most prudent approach, but also the strategy that carries the best chance of long-term and consistent success.
Finally, caveat lector! While this article is intended to be a balanced discussion of what can be termed ‘grey’ issues; as a practitioner who is at times evangelical about the way we do it here at Sarasin & Partners, please bear in mind that this is a subjective look at asset styles and investment choices based on my own personal perspective.
1. See also the Caritas Guide to Risk Management, published May 2010: www.charitiesdirect.com/caritas- magazine/categories/guide-to-risk -management-401.html
2. See also John Chatfeild-Roberts’ article ‘Call to action’, in Caritas, issue 35, October 2010, page 21.
3. For more information about ETF’s, see John Redwood’s article ‘Asset flexibility’ in Caritas, issue 11, October 2008, page 17.
Author: Richard Maitland
Richard Maitland is a partner and Head of charities at Sarasin and Partners.
Richard specialises in the management of long-term multi asset portfolios for charities and has been a visiting lecturer at South Bank University Business School and the University of Stellenbosch.
He is author of the Sarasin & Partners Compendium of Investment for charities
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