Implementing your investment policy
June 2009 Supplement
Once the investment policy statement has been finalised...
...trustees and executives need to consider how to go about implementing the investment policy in a portfolio. This will probably involve outsourcing the management to an investment manager or buying a ready made multi-asset common investment fund.
The planning and implementation of your investment policy needs to put current investment environment conditions in a longer-term perspective and take on board market trends both in the UK and overseas. As one firm of investment managers puts it in their latest guide:
‘While trustees and investors are perhaps more able than ever to create portfolios that match their particular circumstances, agreeing and implementing investment policy still represents a major challenge. As has ever been the case, the key to generating real returns in the future and protecting those already achieved will lie in creating a robust strategic investment policy that matches your particular circumstances.’ [1]
Strategic asset allocation
This is the most important decision to be made, accounting for most of the portfolio return. Asset allocation is the choice between different types of investments (see portfolio components on page 16). Too safe (cash and bonds) and your returns will be small and are likely to be eroded by inflation over the long term, too risky and your capital will be too volatile in the short term. Most go for something in the middle which is where an adviser or manager can help identify the most suitable mix.
Charities often want to maximise their income in the short term, but also need to preserve their spending power in the long term, if the real value of their work is not to shrink over time. These are conflicting objectives because the investments that provide the most income today, such as comparatively high-yielding bonds, are the investments that provide the least long-term protection against inflation. The investments that provide the best long term protection against inflation, such as UK and overseas equities, often provide the lowest immediate income.
In other words the right portfolio mix between the different types of investment is the balance that gives rise to an income which will grow in line with inflation over the years as well as pulling up the value of the capital in line with inflation at the same time.
Trustees should take some time evaluating the correct balance for your portfolio, what level of return can you achieve for your risk tolerance and how much of that return do you spend now and how much do you save for the future? It is this debate that will ensure that your reserves are not depleted now and are protected against inflation over your charity’s long time horizon.
Active v passive asset management
- Tactical asset allocation. Once a strategic asset allocation has been decided upon, you may or may not allow your fund manager to deviate (by a large or small margin) from this central allocation to try and add value or reduce the overall level of volatility. The success or otherwise of these endeavours should be tracked by your investment committee. The fund manager should be able to articulate a clear rationale for each divergence from the central strategic allocation.
- Stock selection. You may or may not also choose to try and add value by selecting stocks or funds that you expect to outperform the wider index. Passive management is where the manager simply replicates a chosen benchmark or index (e.g. FTSE All Share). Active management involves a manager investing in his or her favoured stocks and can perform better or worse when compared to the index. This approach tends to be more expensive but can offer significant improvements in return. Active management requires more analysis by the charity to understand how returns are generated.
Pooled v segregated
Charity trustees can either choose to implement their investment policy by buying equities and bonds directly, by investing solely in pooled funds, or a mixture of both.
Pooled funds include unit trusts, open ended investment companies (OEICs) and common investment funds. In these funds, investors’ money is pooled and used to purchase a diversified portfolio of assets. This portfolio is divided into units which vary in price according to the total net asset value of the fund. For unit trusts and common investment funds there is a spread between the purchase price and the selling price of the units. OEICs usually have a single price.
Common Investment Funds are pooled funds that are registered charities in their own right and are established and approved by the Charity Commission. Only charities can invest in these funds and each fund has an independent supervisory board providing another layer of governance.
The benefits of adopting a pooled approach include diversification of stock, of style, of investment manager as well as ease of administration. The drawbacks include a less tailored approach which may well mean specific ethical policies are unable to be implemented effectively, and also the possible higher fees in pooled funds (although common investment funds tend to be priced competitively).
The segregated approach is more bespoke, however the investment pool needs to be sufficiently large to ensure effective diversification. This is why most charities tend to utilise pooled funds.
Total return v income
Charity trustees can choose to bias their investments towards income or to generate the best ‘total’ return (capital plus income), whether it comes from capital growth or income. Charities that are permanently endowed are only allowed to spend their income, not capital and are therefore often in favour of the income approach. However, you can write to the Charity Commission if you want waiver of this to be considered. An important issue to be aware of when adopting total return is the difference between the predictability (or volatility) of the income compared to the capital year on year.
Absolute/targeted return
Some charities wish to specify an absolute level of return or a target. This can suggest that the trustees wish to put capital preservation relatively high up the agenda and can, as a result, involve a larger allocation to ‘alternative’ asset classes such as hedge funds. This should be discussed with the investment manager as part of the investment policy statement, under the return objective. That said, most ‘relative return’ benchmarks should have been constructed with a level of absolute return in mind, even if expressed over a very long time period.
Inclusion of alternative asset classes
Charity trustees should discuss the level of commitment that they are prepared to make to alternative asset classes. These include hedge funds and private equity. The benefits of including these asset classes can be an enhanced projected return and diversification benefits from introducing new sources of return uncorrelated with the equity market. However these assets tend to be more illiquid, expensive and opaque in nature.
Overseas v UK investment
Historically charities have tended to have a strong bias towards companies listed on the UK stock exchange. This had the benefit of an attractive dividend yield compared to overseas markets and a perceived lack of currency risk. However, there are concentration issues in the FTSE All Share with the top five companies representing over 30 per cent of the market value. The top nine companies pay 50 per cent of all dividends. Overseas investment gives charities a wider opportunity set of companies to invest in. However the impact on income and the risk of investing in a different currency should be considered. It is worth noting that the majority of the earnings of companies listed on the UK stock exchange actually come from outside of the UK. That said, as 40 per cent of UK listed companies account for their profits and dividends in currencies other than sterling and the majority of earnings come from outside the UK, the division between UK and ‘international’ companies is something of a moot point.
Cash management
Two years ago few would have considered that the possibility of banks’ failing would have been a major item on their charity's risk matrices. But rather like pensions in the early 2000s this is an issue that came home with a bang during 2008 with the collapse of Northern Rock, Lehman Brothers and the failure of Icelandic Banks.
Trustees need to consider the financial strength of a particular organisation against the rate of interest being offered and how this compares to the market as a whole. If it is out of kilter – why? Do they need to consider spreading the risk by putting their money with more than one financial institution?
Charities need to consider just how they should invest their cash, balancing their need for income against capital protection. This will be an individual decision for each charity balancing risk against operational requirements. In order to mitigate risk, charities may wish to consider the following option. A charity will put no more than £X in any one financial institution which will have a minimum credit rating of Y. We will aim to achieve a deposit rate that is equal to a common deposit fund.
That leaves the question on just what X and Y should be. Clearly this depends on the risk that charities wish to take. For example Y could be AA. Whilst no charity would want to lose any money, X should be an amount that the trustees feel that the charity could lose and still stay in business. However, whatever you decide as always there are no guarantees; remember that Kaupthing Singer & Friedlander was an AA-rated bank a week before it went into administration.
Whatever you do decide please remember ‘if it sounds too good to be true it probably is’ – trust your instincts and apply common sense.
[1] Sarasin & Partners Compendium of Investment for Charities, 12th Edition
Author: Clarissa Dann
Clarissa Dann was the editor of Caritas as well as an HR and management online service,he People Bulletin until July 2011.
She is now the editor of the specialist trade finance magazine, Trade and Forfaiting Review which can be viewed at www.tfreview.com but does write on charity finance and investment from time to time.
Clarissa has a background in legal and professional publishing, as well as business journalism and holds an MBA from Cass Business School. She has been one of the judges for the non-profit category of the Chartered Institute of Marketing's Excellence in Marketing Awards for the second year running.
She has also acted as clerk to the trustees of a small almshouses charity and as a member nominated trustee to a pension scheme of a multinational publishing company.
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