How best to review your charity's investment
performance
Ongoing legislation affecting UK charities has brought the focus of many trustees onto the way their investments are managed. The Charity Commission's document "Charities and investment matters: a guide for trustees" (known as CC14) has highlighted the requirement for trustees to review their investments to ensure that performance is acceptable over time.
Where an external investment manager has been appointed, additionally the investment manager should be placed under scrutiny and trustees must be extra vigilant to ensure that charity funds are not diminished by poor management.
In seeking to review investment performance, many charity trustees may feel that they do not have the relevant information, investment insight and expertise to judge portfolio performance. Indeed, assessing performance is not a simple task! It is not just a question of looking backwards at return numbers but understanding the risks being taken to generate those returns.
More in-depth analysis can reveal risks that can be mitigated before they lead to performance disappointment. Factors such as liquidity, transparency of pricing and complexity are just three examples of risks that trustees might wish to consider in a portfolio review.
However, for the purposes of this article, let's consider three areas that charities may initially wish to focus on when conducting an investment performance review: accounting for conflicting time horizons; selecting appropriate measurement yardsticks; and adopting a robust, systematic approach to addressing any findings.
Dealing with conflicting time horizons
The investment time horizon for a portfolio is often 10 years or more; in the case of endowment funds it is theoretically infinite. However, for most charities the amount of money available for investment is not a constant. Rather it waxes and wanes according to the funding cycle of the charity. It therefore becomes important to understand how the investment portfolio is performing over much shorter periods as this has a direct influence on the scope of charitable activities being planned for the future.
In practice, performance is usually considered on at least a quarterly basis. The problem which arises as a consequence is that a long term investment objective becomes overshadowed by short term fluctuations in equity and bond markets. To avoid being carried away by sentiment swings and the latest "zeitgeist" a balancing act is needed with the trustees mindful of the long term goals but receiving regular updates and undertaking regular reviews.
A start might be to review performance on a discrete quarterly and calendar year basis, but also to review rolling one, three and five year periods. Trustees should certainly aim to give a new portfolio manager at least 36 months before being tempted by a replacement unless performance is abysmal or corporate changes, such as mergers or key staff leaving, cause concern.
Selecting a measurement yardstick
When setting the investment objectives for a portfolio, the law requires that charity trustees are satisfied that the overall level of risk being taken is appropriate for the charity given its objectives. In other words, both target risk and target return (capital and income) need to be considered and quantified. As well as forming part of an investment policy statement, these key factors are typically expressed in a "benchmark" against which future performance will be judged.
The Charity Commission suggests taking expert advice when setting benchmarks and historically a market index or composite of indices has been used. However, these can be misleading and even unhelpful as the sole measure placing portfolio performance into context.
A more robust approach is to consider using four yardsticks: cash; the manager's benchmark; "cash +X%"; and a suitable peer group. Let's look at each of these in turn.
Cash is easy to reference and currently relatively easy to beat. Many trustees take the view that if the charity investment manager is not tasked with at least beating the return of cash over time there is little point in investing at all. Cash can be thought of as a proxy for the "risk-free" rate of return.
Traditionally, investment managers have used financial market indices (such as FTSE All Share; MSCI World Equity; Citigroup World Government Bond; etc.) or composites of such indices as benchmarks against which relative performance can be measured.
Usually, the benchmark is a composite of financial market indices including equities, bonds and cash in appropriate proportions, representing the various asset classes and opportunities into which the manager can invest. The investment managers objective is then to beat this composite benchmark after costs. The main advantages of using a basket of financial indices as the basis for assessing portfolio performance are simplicity and transparency.
More recently, absolute return style mandates have become popular and managers have been moving towards "cash plus X%" measures or "inflation plus Y%" targets. Both have their merits. This type of benchmark is arguably the most appropriate one for charities which do not have a fixed life and are seeking to maintain a real level of giving each year into the future.
Absolute return style benchmarks allow the manager much more flexibility with asset allocation than the traditional index composite approach; for example, there is scope to reduce risk and preserve capital in falling markets. The objection to these as stand-alone benchmarks is that it is difficult for a trustee to quantify whether the target is challenging enough and whether the manager is adding value or being "given" the targeted return by the financial market.
Finally, there is peer group performance or "what could I have got elsewhere?" There are now peer group indices available which reflect the "opportunity set" available and provide a reference to illustrate how any investment manager is performing against the industry average.
Adopting a systematic approach
Once a series of performance yardsticks have been established, a systematic approach to assessing portfolio performance should be applied. This process needs to go beyond purely looking at returns and encompass risk and consistency amongst other factors. There is no 'silver bullet' statistic; rather any quantitative approach will need a qualitative (commonsense based) overlay.
As a starting point, trustees should consider whether returns are in line with their expectations and whether the risks that are being taken are tolerable. Is the return per unit of risk acceptable? Has the pattern of performance produced any surprises? Other considerations such as liquidity, transparency of pricing and complexity are just three factors that trustees might also wish to assess in a review.
There are a number of technical and practical difficulties in implementing a systematic, standardised approach to performance assessment including: data collection issues; treatment of fees and charges; impact of investment constraints; and how to deal with strategic holdings amongst others. However, without a systematic process, evidence of an audit trail becomes much harder to maintain and making a decision to change a manager becomes a more qualitative judgment.
In addition, by adopting and rigorously following a systematic procedure including a robust escalation process when questions or problems have arisen, the visceral aspects of manager change are ruled by evidence rather than emotion.
Make time to discuss investments
In practice, trustees should consider using a range of measures to ensure their investment policy is appropriate, reflecting the relevant time horizon of the charity and, crucially, the interaction of fundraising with grant giving over time. Assessment of any external investment manager should be multi-faceted and include more than just comparing returns versus a traditional index-based benchmark.
This is not always straightforward. Trustees may only meet twice a year so it is incumbent on the investment manager to assist trustees through regular and timely reporting. Detailed and regular communications remain the key to success. Some charities tackle this challenge by having separate finance or investment committees enabling them to monitor their investments more regularly and in-depth. Others appoint independent investment advisers to hold the investment managers to account.
Monitoring investments to ensure that charity assets are not mismanaged and establishing robust and objective methods of assessing manager performance, given the increased legal requirements, must be treated with the seriousness and attention to detail that it requires.
