Thinking about changing your investment manager
Investment markets constantly surprise and often throw up unexpected warning signs to charities which do not have a regular review process in place. Factors such as poor performance, corporate change of the investment manager or declining service standards are good warning signs that might cause a change in an investment manager. In reality, charities tend to move slowly and be more forgiving of poor results in the short term. A regular investment review programme will help trustees manage expectations and identify warning signs before they have a significant impact on the charity.
Charities which are investing money for long term capital gains and income need to keep these investments under review. It is the trustees’ responsibility under the Trustee Act 2000 to ensure the assets invested are properly maintained and are suitable for the needs of the beneficiaries. The Act identifies the need to review investments with regard to the "standard investment criteria", to ensure the assets are suitable and diversified so far as it is appropriate to the circumstances of the charity.
The Act goes on to state that trustees must exercise their "general power of investment". This effectively means that a trustee may invest for the charity in any way, as if they were absolutely entitled to the assets of the charity themselves, subject to any provisions laid down in the charity's governing document which may place some conditions or limitations on the use of any power of investment.
Periodic basis
Trustees should review their investments, the Investment Policy Statement and managers on a periodic basis. While the timing of a periodic review is not defined, it is advisable to hold a formal annual review of the Investment Policy Statement and any restrictions or ethical criteria to ensure the investments held are still suitable for the charity's objectives. The overall performance, levels of income generated and risk being taken should also be taken into consideration.
Having carried out an annual review, if trustees feel it is necessary to carry out a formal review of their investment manger, it should be done in relation to the competitive market, by reviewing prospective investment managers and comparing them against the incumbent. This can either be done as a "desk-top" exercise, via a written tender with questionnaire and beauty parade or by employing a consultant to conduct the review. As part of good governance it is advised that this should happen every three to five years, which has historically been regarded as a business cycle, depending on which economist you believe!
Trustees should prepare the review addressing a variety of criteria including:
- Whether the terms under which the investment manager is acting are suitable.
- How well the manager is performing.
- Whether the manager continues to be a suitable firm to carry out the function.
- Whether the terms of the appointment remain appropriate.
- Whether the manager is complying with the policy statement.
Trustees must obtain and consider proper investment advice from a qualified person when carrying out a review, having regard for the standard investment criteria, unless they conclude it is unnecessary or inappropriate to do so. Charities are increasingly appointing trustees who have appropriate investment experience or co-opting a qualified investment manager to assist on a pro bono basis.
Rigid process
Given this onerous task, it is unsurprising that many charities do not have a rigid investment review process. Furthermore, many trustee board meetings are dominated by grant-making, governance, fundraising or other pressing short term financial issues. Providing the investments are growing, income is sufficiently meeting the charity’s budget and the manager is providing satisfactory information, the investments are likely to be given less attention.
Larger charities may have the benefit of appointing a finance or investment sub-committee to give focus, but smaller charities may not have this luxury or may feel it unnecessary to have this level of governance. Partly for these reasons, charities tend to appoint an investment manager on a discretionary basis, delegating investment decisions to the investment manager on a day to day basis having agreed a suitable investment policy at the outset.
Charities tend not to review their investments as much when markets are rising and performing well. Conversely, after a fairly low return for most charity funds in 2014 and what is shaping up to be a lacklustre investment performance in 2015, it would not be surprising for charities to give their investments greater scrutiny. The heightened volatility of markets this year may prompt trustees to look at the amount of investment risk they are taking.
When measuring investment performance, it is important to ensure you are comparing like with like. It is usual to compare individual years and 1, 3 and 5 years of cumulative performance, net of investment management fees. Clarity about the date you want to compare performance to is also vital. Short variances in end dates can create significant differences in performance between funds. For a more complete comparison, charities may wish to review the risk adjusted return, taking into consideration the level of risk taken for each percentage of return.
The review of the charity’s investment performance can be carried out in conjunction with the investment manager, but it is advisable that the review of the service provided by the investment manager should be carried out independently of the investment manager. Terms of service are also a vital area to clarify in a tender. Investment managers will either supply a full discretionary service with dedicated investment management individuals reporting to the charity or simply supply a pooled investment fund and periodic reports. Higher levels of service do cost more and trustees need to take this into account.
Acceptable reason
Of course, just because a charity’s funds are underperforming should not trigger an automatic tender. Trustees should seek to understand whether any underperformance is for an acceptable reason. Most investment managers go through periods of underperformance, mainly due to their investment style or process being unsuited to prevailing market conditions. Trustees need to ensure the manager doesn’t change their style or add risk to try to improve performance. Similarly, if funds are performing significantly above average, trustees should ensure that it is not because the charity is exposed to greater risks than it is prepared to accept.
Other warning signs that might cause a charity to conduct an investment review include;
- A prolonged period of poor investment performance.
- A corporate change of the investment manager or charity – merger or acquisition.
- A change in the investment strategy – driven either by the charity or the manager.
- The individual or team responsible for managing the investments moving to a new firm.
- A significant change to the services offered by the investment manager – withdrawal of discretionary services, custody, etc.
- A significant change in the financial position of the charity – sale of property, a large donation, legacy gift, change in grant making, planned capital expenditure, loss of service contract or income
- Change of the charity’s treasurer, executive or trustee.
If a charity decides to review and tender its investments, the first thing trustees must do is to review and update its Investment Policy Statement. It is important to ensure that the policy is relevant to the needs of the charity, addressing any restrictions, clearly setting out the investment objective and means of measuring performance. The policy statement also needs to state the service levels expected of the investment manager and frequency of reviews.
One area of contention comes down to the descriptive terminology of an investment portfolio. Charities often refer to a "balanced" portfolio, which might mean the requirement to produce a balance between capital growth and income. It could also imply a balance of risk between real assets (equities, property, commodities) and monetary assets (bonds, cash). Given the long term investment horizons that charities tend to exhibit, it is fairly common for a "balanced" portfolio to include between 60% – 80% investment in equities, while an investment manager may regard a balanced portfolio to have a maximum of 50% in the asset class.
Understanding risk
Risk is a subjective measure and probably one of the most debated issues concerning investment. It is vital that a clear understanding of the overall risk is shared between the charity and its investment manager. While it could be argued that it is for the investment manager to propose the most appropriate asset allocation to meet the brief, trustees should be realistic that a higher equity weighted portfolio may have produced higher historic returns but can be riskier in the short term.
Investment management fees are notoriously difficult to compare, notwithstanding increased regulation to give investors greater transparency. Investment managers should now quote an Ongoing Charges Figure (OCF), which is made up of the annual management charge to manage the investments and any other operational costs, such as any underlying third party investment management charges, entry fees, custody, audit, regulatory, dealing costs and VAT. Investment managers have to produce this information in a clear format and charities must ensure that they receive it, although It is a confusing area.
Trustees should decide on a system of target returns (for example benchmarks) against which they can measure the performance of the charity’s financial portfolio over a specified time period. The precise nature of the benchmarks and targets will vary for each charity. The trustees may also wish to consider and compare the performance of their funds against those belonging to other charities with similar investment objectives. These figures are relatively easy to obtain and firms such as WM (State Street) and ARC (Asset Risk Consultants) provide quarterly charity peer group performance.
Investment managers which mainly invest for private individuals may use the Wealth Management Association (formally APCIMS) indices to compare performance. There are certain flaws with these indices, as they are not constructed for charity investors and there may be a tendency for the investment manager to remain closely invested in line with the benchmark, leading to higher volatility.
Who should conduct the review? Ultimately it is the trustees’ responsibility to appoint an investment manager, but they may delegate the review process to a sub-committee which should have appropriate time, skill and qualification to manage the process. Trustees may wish to take expert advice from an independent organisation, such as an investment consultant, which will charge to manage the whole review and tender process. The review can take a few months to complete if formal questionnaires are submitted and beauty parades are carried out. Once a decision by the sub-committee has been made, it is then discussed and agreed by the board of trustees.
Open mind
Trustees should have an open mind, as it is not uncommon for the outcome of a quantitative and qualitative review to result in no change of investment manager. They should always remove personal preferences and biases from the selection process. Trustees should be under no illusion that the administrative demands, security checks, form filling and costs of switching investment managers are quite onerous.
While there may be some obvious warning signs to prompt a review, charities should have a regular review process in place and only change their investment manager when it is appropriate and necessary to do so, as part of good charity governance. Further information is given in the Trustee Act 2000 and the Charity Commission’s guidance (CC14), How to invest charity money, offers useful advice to trustees on investment reviews.
Finally, while the review process can be lengthy and time consuming for the charity, it is also time consuming for the prospective investment managers who can spend a number of days completing the tender documentation and interviews. No matter what the outcome of the review, charities should be mindful that it is always polite to give objective feedback. Investment managers which were unsuccessful in the tender always welcome this.
