Trustees of charitable investment funds are having a torrid time. Many charitable funds have been badly buffeted by the market declines of the last year. Trustees have been left wondering what to do, as equities fall around the world on fears of economic downturn or recession, as commodities climb rapidly and then subside, and as inflation rises, undermining the real value of bonds. Many charitable trustee bodies and investment committees effectively make their own decisions on asset allocation, often just meeting two or three times a year to review the target bands for different assets or to make decisions about switching money between funds and managers.

There are several problems with this way of approaching investment. The first is that switching between different funds or selling and buying different equities, is an expensive process. Trying to find a manager who will beat a given index through his investments for you in equities or bonds is difficult. The charity pays good money to investment managers to make the less important decisions – which shares – and leaves the important decisions about which markets to the trustees. Even with very experienced trustees, knowledgeable in investments, there are difficulties if major events or big changes of view occur between meetings, preventing the charity from adjusting its exposures.

In the summer of 2007, there was a defining change and series of events. On both sides of the Atlantic the money markets froze in August, and caused serious problems for financial institutions in September. All too many charities were unable to respond and to protect their assets, because they were not due to meet until October or November, after some of the fall had occurred. That made it more difficult for them to take evasive action, as the price of portfolio insurance or the sale value of the shares had moved against them.

 

One way to improve a fund’s chance of doing well for the charity is to concentrate more on the asset allocation. You cannot avoid having a view on markets through the choice of how much to hold in shares or property or bonds or cash. Keeping within long-established bands or deciding it is too difficult to switch is a decision on asset allocation. It also happens to be the decision which will have most impact on your fund’s performance.

Academic work shows that asset allocation is central to performance. The Brinson, Hood and Beebower studies, the Ibbotson and Kaplan study and the Drobertz and Kohler study (see table below) all show 99 per cent or more of the portfolio’s performance coming from the choice of asset, with share selection in some cases subtracting up to 34 per cent from the return. Our own study of London-based specialist funds shows that seeking a fund which can reliably outperform is not an easy task, and you can only be sure after the event. On average you would expect equity funds to underperform equity indices by the costs of dealing in the shares and their fees.

 

 

 

 

Source: Evercore Pan-Asset Capital Management

 

It is not possible to index the asset allocation. There is no single index of a typical portfolio. Most investment advisers will tell you need to tailor your portfolio to your own needs, examining how much risk you wish to accept, how much income you need and what your cash requirements are in the future.

 

While it is not possible to offer a ‘magic box’ solution to choosing assets which will always deliver good performance and will be right for your fund, it is possible to index your portfolio of shares in different world equity markets. Many pension funds have chosen to buy unit funds which seek to match the portfolios and performance of the main equity indices to reduce the risk of losses from stock selection.

Today there is growing interest in exchange traded funds to implement an asset allocation strategy. Exchange traded funds have been designed to allow you one purchase to expose your portfolio to a whole market. If, for example, you want your fund to be invested in US equities, you can choose to buy shares in a fund which matches the performance of the S&P 500 or the Nasdaq 100 almost exactly.

Shares in the ETF are traded on a main exchange like shares in BT or Exxon. The ETF itself owns a portfolio of shares that replicates the index it is seeking to match, or it owns a portfolio of shares that is quite like the index, augmented by contracts for differences to make sure the performance will be in line with the index. This synthetic route lowers costs and makes dealing in the underlying shares easier, by leaving out small or difficult to deal companies for example.

Even after allowing for the expenses of running these funds, the better ones in the main equity markets can almost exactly match the performance of the underlying market. For example, Lyxor Nasdaq 100 ETF has had a tracking error of only 0.01 per cent since it began in 2002, whilst the iShares S&P 500 ETF has only lost 0.07 per cent per annum against the index over a similar time period.

Why, some will ask, should we accept index-matching performance? Surely there are managers who can do better than that for us? Yes, over certain time periods some managers do outperform the index they are asked to beat. Many funds do still seek them out with a portion of their capital. The problem is in finding them in advance of their good performance, given the average experience, which is one of underperformance.

How then, can exchange traded funds get rid of most of this underperformance? Firstly, they do not make mistakes by buying and selling shares at the wrong times, in the way active managers can. Those which replicate the index always buy or sell the right amounts of shares to keep their portfolio in line with the index. The synthetic funds achieve the same aim by putting in place portfolio insurance to match the index. These funds do, however, still need to offset their own fees and their own transactions costs for the buying and selling they do have to do to balance their funds. One of the ways they do this is through stock lending against their share positions, an accepted practice in major stock markets where the shares are returned to the fund at a specified date and a fee is earned.

Not all exchange traded funds match or nearly match their index. The more exotic ones have higher fees. None of them can offer a firm guarantee, but the more mature ones which have established a good track record show what can be achieved in usual conditions. This is much better than the average actively managed fund.

Exchange traded funds are a cross between unit trusts and investment trusts. Like investment trusts you can deal in them any time the market is open. Unit trusts have dealing times or dealing days when you can apply to buy or sell units, so they are less liquid. However, unlike investment trusts and like unit trusts, if there is a big buyer or a big seller of the ETF, whose bargain cannot be accommodated by market makers in the normal way, the manager can create or destroy shares, buying or selling the underlying shares in the ETF portfolio, to increase liquidity. The aim is to prevent the ETF ever going to a significant discount to asset value through pressure of selling – or to a premium through pressure of buying, in the way an investment trust does.

This means ETFs are effectively as liquid as the underlying market. There are two pools of liquidity available if you wish to sell. There are the market makers in the ETF shares themselves, who may buy your stock to sell it on. There is the liquidity in the shares within the ETF portfolio, where money can be raised to redeem your shares if need arises. There are no entry or exit fees. Dealing spreads are usually tight. Management fees are lower than for most actively managed funds. Typically the fee would be 0.2 per cent for cash or bond funds, between 0.3 per cent and 0.7 per cent for share ETFs and between 0.4 per cent and 0.9 per cent for alternative investments.

You also know every day what your exposure is like, as you can always find out what shares are in the underlying index are tracking. In this sense they are more transparent than many actively managed funds, where you do not know day by day what they own.

Apart from low tracking error after costs, they can make running a portfolio easier. A single trade can give you your whole exposure to, say, Japanese equities, and a single trade can take you out of Japanese equities when you wish. It gives you an easier and cheaper way of changing policy if circumstances in the markets or your own circumstances change.

 

Exchange traded funds were first launched in the USA in 1993. There has been big growth in them, especially in the US. By the end of 2007, there were 1200 ETFs worldwide, controlling assets worth $800bn. They allow you to pick and choose in a number of ways when settling your investment approach. The simplest way of using them would be to own shares in an ETF, giving you exposure to world equities when conditions are good, and to switch to ETFs in cash and short-term bonds when times are hard. If you get this choice right more times than wrong you will do well.

If you wish to run a more traditional portfolio, with a mixture of bonds, property and equities, there are ways of doing that through ETFs. There are ETF invested in index- linked bonds, different country government bonds, corporate bonds and interest rate spreads. There are ETFs that invest in money market instruments, and ETFs that buy property shares to give you exposure to property portfolios.

If you wish to be more discerning in your equities, there are ETFs for each major world market and its relevant index. You can use ETFs to move from Asia to America to Europe, or from Japan to the USA to Germany. You can construct a balanced equity portfolio from ETFs seeking to match the performance of differing equity markets.

If you wish to take more active management risk, there are now ETFs that replicate or mimic sector performance, so you can buy into oil shares or technology shares through an ETF.

Perhaps more attractive is the ability for a portfolio to put its toe into the waters of alternative investments like private equity and commodities through ETFs. The ETF is more liquid, more transparent and with lower fees than most of the usual ways of investing in these areas. You are not locked in for months or years, the fees are not high, and you know more about what you are buying.

Unfortunately there is not an ETF which will always get the asset decisions right! You still need to do that for yourself, or take advice from those who might be able to help you.

Author: John Redwood

John Redwood is the co-founder and chairman of Evercore PanAsset, who offer investment advice on asset allocation and ETFs.

He has a long background in business, including being an investment and research director at NM Rothschild, chairing a substantial listed industrial company, and acting as a trustee of pension and charitable funds.

www.pan-asset.co.uk

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