Why exchange traded funds can be right for charity investors

The development of investment markets over the last decade, culminating in the credit crisis and volatile markets have caused charity trustees to focus on the key issues when making investment decisions. Clearly risk and return remain essential determinants, but a few other factors have become dominant when assessing investment, namely transparency, complexity and costs.

Many trustees have a long term time horizon when investing on behalf of a charity and are prepared to take risk. Many will delegate the investment decision to a qualified fund manager to meet the specific investment requirements of the charity. Many trustees still have a traditional view of investments and tend to favour an actively managed fund or investing directly into specific shares or bonds. None of this is wrong or bad, but there is an alternative approach to charity investment by using passive funds to gain exposure to markets or assets.

Passive fund investing has gained traction in the UK over the last decade and is somewhat confused as there are a number of terms or variations of the theme; occasionally referred to as passive funds, index funds, tracker funds and exchange traded funds or products (ETFs and ETPs).

The concept of passive investment is not new. The idea was developed by John Bogle in the US who took his university thesis, "Mutual Funds can make no claims to superiority over the Market Averages" and founded The Vanguard Group in 1974. Simply put he thought that active fund managers, after costs, rarely outperformed their respective benchmarks. He launched the first index fund in 1975 to track the performance of the US equity market (S&P 500 Index). Seasoned investors at the time criticised this method of investment stating that “they couldn't believe that the great mass of investors are going to be satisfied with receiving just average returns".

Growth in popularity

Numerous other institutional investors in the US established similar passive funds for pension funds in the mid 1970s. Notwithstanding the sceptics, the passive investment market grew in popularity and became available to retail investors. Vanguard funds mushroomed and the firm became one of the largest fund management groups globally. The birth of the exchange traded fund occurred in 1993 with the Standard & Poor's Depositary Receipts (SPDR) commonly known as ‘Spiders’, and also based on the S&P 500 US stock market index.

Barclays Global Investors developed this idea in 1996 with the launch of World Equity Benchmark Shares or ‘WEBS’. This enabled US retail investors to invest internationally with ease through a New York Stock Exchange mutual fund for the first time. Barclays subsequently rebranded its passive fund range as iShares and the business was sold to BlackRock in 2009. State Street Global Advisors were also an early developer of ETFs, entering the market in 1998.

It is therefore no coincidence that BlackRock iShares, State Street and Vanguard are the leaders in the passive fund market, although many new entrants have launched their versions of ETFs in recent years. These have notably been large retail banks or financial firms such as HSBC, Credit Suisse, UBS, db x-trackers (Deutsche Bank), Source (Bank of America/Merrill Lynch, Goldman Sachs, J.P. Morgan, Morgan Stanley and Nomura), Lyxor (Société Générale) and others. Passive funds have grown in popularity in Europe over the last decade and this has mainly been through ETFs. Their growth in net new assets has been exceptional and by the end of September 2012 there were US$1.85 trillion invested in 4,748 ETFs or ETPs globally according to BlackRock research.

ETF Growth Rate

While passive funds and ETFs can be used for short term trading, they are best and mostly used for long term asset allocation. It is increasingly recognised that the long term performance of a charity investment portfolio is derived from which asset it invests into rather than the stocks it holds. Passive funds have an important role to play in this respect.

There are many myths and concerns surrounding passive funds, so to assist charity trustees, there are some useful facts that should assist with their general understanding.

STRUCTURE. Passive funds in general are unit trusts or open ended investment companies (OEICs) which are priced closely to the net asset value or NAV (the collective value of the assets held in the fund). They are not listed on a stock exchange but traded through a fund manager. An ETF differs in that it is listed on an exchange and offers daily liquidity when the market is open. It has the advantage of a higher governance structure, similar to an investment trust and must comply with the exchange listing rules.

Passive Fund Structures

HOW DOES AN ETF WORK? An exchange traded fund (ETF) is an investment vehicle which is constructed as an open ended collective investment scheme and trades like an individual security on a stock exchange.

ETFs are UCITS III compliant (European fund management regulation), open ended collective investment funds which seek to track the performance of a benchmark index. ETFs are the most common exchange traded product available in Europe and globally today. ETFs can either track their index through holding the underlying securities, so called physical-based, or alternatively by holding a derivative, called synthetic or swap-based. ETFs offer investors transparent, flexible, liquid and cost-effective access to virtually any asset class.

Particular benefits

In many ways, they are similar to any other collective investment, such as a common investment fund or unit trust, but ETFs provide investors with a variety of benefits over traditional funds:

LOWER EXPENSES: In general the total expense ratio (TER) for ETFs ranges from 0.5% to 1%. This compares favourably to an active fund where typical charges vary between 0.75% to 2% or more.

TRANSPARENCY: Most ETFs disclose on a daily basis the exact holdings of the funds so you always understand precisely what you own and what you are paying for.

FLEXIBILITY: ETFs can be bought and sold at current market prices at any time during the trading day on a recognised exchange, unlike unit trusts, which can only be traded at the end of the trading day or once a week.

INCOME: Most ETFs distribute income, which will be based on the underlying assets held.

DIVERSIFICATION: In most cases, an ETF will offer wide diversification across an entire market by holding all or most securities in the index.

NO ACTIVE MANAGEMENT RISK: An ETF simply tracks a particular market or index and doesn’t make judgments on the constituents of the index it follows. Therefore there is no risk that a fund manager who actively picks underlying investments will do a bad job and underperform the index or benchmark they are following.

Buying an exchange traded fund gives exposure to a specific market. In essence, ETFs provide the building blocks to produce tailored investment portfolios. Investors can buy several ETFs over several markets in order to implement a tailored asset allocation strategy.

ETF Replication Methods

ETFs either purchase all the assets which make up the index they intend to follow or partly so. Alternatively they may enter a derivative contract to gain exposure to an asset. Funds which invest in commodities and other esoteric assets offer higher risk as they introduce higher counterparty risk.

Swap-based funds will have a higher risk profile when compared to their physical-based equivalent, because of their exposure to the swap counterparty. However, under the UCITS rules, this exposure is limited to a maximum of 10% of the value of the fund and in most cases this is much less. Therefore should the counterparty fail the maximum loss to the fund is 10% as the underlying collateral will be returned to the investor.

Mitigating risks

In order to mitigate the risks of the existing swap-based ETF structures, various ETF providers offer funds which have multiple counterparties and hold more collateral than the value of the counterparty exposure. The quality of the collateral and over collateralisation help investors to protect against counterparty default risk at all times. Most providers of synthetic ETFs share daily collateral and index holdings, swap counterparties and aggregate swap exposures on their websites to provide transparency in line with the physical-based ETFs.

EXCHANGE TRADED COMMODITIES (ETCs) and EXCHANGE TRADED NOTES (ETNs). ETCs issue debt securities which trade on exchanges offering investors direct exposure to commodities. By investing in ETCs investors gain the desired exposure without the need to trade physical commodities or commodity futures contracts. Similar to ETCs, ETNs are debt instruments which tend to be issued off the balance sheets of the issuing entity, typically a bank or special purpose vehicle.

ETNs offer exposure to a broad range of asset classes and trading strategies. ETNs are neither funds nor exchange traded funds and the level of counterparty risk can vary depending on the issuer. They are therefore considered to be higher risk and not suitable for retail investors. In addition, those funds which use derivatives to gain exposure to a commodity may find the performance varies significantly from the price of the commodity it tracks.

HOW TO SELECT A PASSIVE FUND. The selection of a passive fund or ETF is no different from any other type of investment. The first step starts with the selection of an asset, such as a share, bond, property, etc. Having decided which country or sector, the next step is to review the available universe of passive funds available. This can be done on a number of comparative fund analysers or simply via providers’ websites or even Google. Key factors include:

• Knowing what the fund owns and understanding the index it is following.
• Physical or synthetic replication?
• What are the total costs?
• Understanding the fund’s liquidity.
• An evaluation of the fund provider.

It is important to remember that every index is unique. Two indices which cover similar areas of the market – even with similar sounding names – can differ greatly from each other and will possess their own unique risk/return profile. This will have implications for performance.

Costs consideration

Costs are a key consideration when selecting a fund. Understandably, the TER – the total paid to cover the costs of fund management, trustees, licensing and operational costs – is an integral part of the choice making process. ETF portfolio managers can also take a number of actions that provide additional revenue which can be used to offset these costs, such as securities lending or the proceeds of the swap agreement. The "true cost" is usually the difference between the performance of the fund after all costs and the index it follows. In many cases this can be as low as 0.05%.

A fund which is highly liquid will be easier and more cost-effective to trade. Conversely, poor liquidity can translate into difficulties in buying and selling, in addition to higher trading costs.

The size, scale, expertise, and commitment of a fund provider are important and vary significantly. While the popularity of passive funds has increased dramatically, there are a number of recent ETF providers who have closed funds and pulled out of the market recently as their operations have proved to be sub scale.

The Exchange Traded Fund Universe

THE RISKS ASSOCIATED WITH PASSIVE FUNDS. As with all investments, a charity trustee should carry out proper analysis or take professional advice before making a purchase. While passive funds offer many advantages over active or traditional funds, there are risks and associated concerns that should be considered:

Like all investments there can be market, custodian and counter-party risks as outlined above.

POOR PERFORMANCE. Some ETFs may not track the index closely and have a large tracking difference.

CHOOSE YOUR INDEX CAREFULLY. The index which is being tracked may not reflect the performance of the asset class the investor wants to track, for example a fund which invests in ‘Emerging Markets’ can vary between Asia, Latin America and Eastern Europe resulting in very different results.

FUNDS WHICH GEAR OR SHORT A MARKET. Some funds can go "short" or sell shares they do not own in the anticipation that a market will fall and they can buy back the shares at a cheaper price (inverse). Alternatively a fund may borrow and leverage the assets in the fund (typically x2 or x3 the value of the assets). These types of ETFs are only suitable for intra-day trading by qualified investors and may not behave in the way expected over a longer period.

REGULATION. ETFs are not covered by the Financial Services Compensation Scheme if they are bought by private individuals without advice from an FSA authorised entity.

In the past year many regulators have cast a spotlight over the passive fund market, especially regarding ETFs. The focus has been towards synthetic ETFs, which have attracted regulatory attention from the Financial Stability Board, the International Monetary Fund, the Bank of International Settlements and the Financial Services Authority. Areas of concern include the lack of transparency in products and increasing complexity, conflicts of interest between fund providers and swap counterparties and lack of regulatory compliance.

Systemic risk

There is concern that misuse of ETFs or the excessive use of derivatives could pose a systemic risk for financial markets. Given the significant growth of ETFs and their availability, it is reassuring that the regulators are giving this area attention. In reality, the systemic risk is much lower than expected as all ETFs accounted for 3.4% of global market capitalisation by September 2012, so have a long way to go before they compete with active management or pose systematic risks considering the overall size of open global derivatives which amount to US$3 trillion.

VERY IMPORTANT FOR CHARITY INVESTORS. Passive funds have a key part to play in charitable investment and are growing in funds under management. Contrary to myth, passive funds are an established method of investment and are here to stay. The recent strong growth in passive investment funds, during volatile markets, has aroused the attention of market regulators, but they have recognised that in their simplest form ETFs are a safe investment.

When used sensibly for long term asset allocation purposes they offer a simple, transparent, liquid and low cost investment alternative to active fund management. For these reasons alone, charity trustees should consider them as a core part of any portfolio.

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The capital value of many charity funds has been damaged in recent years by negative equity market returns and higher volatility of returns. A general reduction of income yields in a low inflation world has added pressure on trustees to generate sufficient returns to meet their charitable objectives. Various academic research has concluded that over 90% of portfolio returns are driven from the strategic asset allocation adopted.

While charities still need to generate a return in excess of equities and bonds, they are adopting a greater appreciation of the risk being taken. In a similar pattern to UK pension funds, we are seeing a gradual shift away from traditional asset allocations.

Two main factors have driven the changing nature of UK charitable investment policies away from the UK centric investment portfolios which existed prior to the Trustee Investment Act 2000. The first reason has been the recent historically cheap cost for developed sovereign nations to borrow money. We are living in an era of financial repression.

This is a mechanism where governments issue debt at lower interest rates than would otherwise be possible. The low nominal interest rate can help governments reduce debt servicing costs, resulting in extremely low yields on higher rated government bonds.

The outcome is that investors purchasing these government bonds as a safe haven accept a negative real return on their investment. This is currently the case for bonds issued by Switzerland, Germany, France, the Netherlands and the European Financial Stability Facility. Index linked bonds have sold with negative yields at auction in the UK, US, Sweden and Canada for some time.

Secondly, economic globalisation and the opening up of emerging country stock markets have meant that charity trustees do not need to restrict themselves to investing in domestic equities and instead can look to alternative investments for superior returns. Both these issues have changed the make-up of charity investment portfolios and, as a result, investment risk.

Charity trustees are placing a greater emphasis on strategic risk or the risk of not having the best type of assets in their portfolios. After losing money, the biggest investment risk to a charity is not meeting its investment objectives. While charities are deemed to have a long term investment horizon, recent high asset volatility has not resulted in higher portfolio returns. Put simply, charity trustees are not being rewarded for taking higher risk as they have done historically.

The long term asset allocation will be a driver for the strategic risk, while active risk is derived by the actions of the fund manager employed, usually on the underlying investments or shares held. Chart 1 demonstrates the emphasis of strategic risk over active risk as measured by the WM Charity Universe over the last 3 years. The average level of strategic risk is 12% p.a. verses active risk of 2%. While charity trustees have to have a level of strategic risk, they can mitigate the active risk by investing into passive funds.

It is also interesting to compare the overall asset allocation of the WM Charity Universe since 1992. Overall equity allocations have reduced from 78% to 65% by 2011. While bonds, property and cash have remained largely static in allocations, the proportion of charity assets invested in alternative investments has grown from 0% to 10% over the last 20 years. A more pronounced shift in asset allocation has occurred over the last decade as Chart 2 demonstrates.

The reliance on equities in charity investment portfolios is the subject of a perennial debate between trustees and their asset managers. If we look at the returns from UK equities over the long term, as analysed in the latest Barclays Gilt Equity Study, it can seen that over the long term equities have performed well. Since 1899 UK shares have returned 4.9% annually on average.

If the time frame is shortened, the excess return from equities over UK government stocks, which are perceived to have less risk, reduces and over the last 20 years gilts outperform. Such is the effect of low interest rates and inflation, with a popping of a few equity bubbles!

Further analysis of these UK shares and overseas equities is noteworthy in establishing where the return is derived from. One reason why charities hold equities in portfolios, especially UK shares, is the relatively high level of income received by way of a dividend. When compared to UK pension funds, charities have tended to invest in more defensive or higher yielding shares.

Whether this income is distributed to fund charitable grants or accumulated, the importance of a degree of capital appreciation and dividend income is striking. Between 1950 and 2011 the annual total return on UK shares was 6.15%. Breaking this return down, only 27% was derived from the capital gain while 73% was achieved by dividends paid out. This comparison of return is more extreme over the longer term.

With the exception of Japan, the difference of return between capital and income is much more balanced with other foreign shares but the hunt for yield by charities is encouraging them to look overseas. This brings us back to the change of asset allocation seen in Chart 2 and the reason strategic risk has remained elevated as seen in Chart 1.

The cult of equity and its demise is a much discussed topic in investment circles. While charity trustees have had a dismal return from shares recently, they do have their place in portfolios as the income they provide is useful. Given there has been a greater focus on investment risk by charities, I remain concerned that there is still an emphasis on investing in developed country sovereign bonds.

The financial repression through quantitative easing (QE) suggests that investing at the current low level of Treasury yields is a very bad option. Investors who bought Treasury bonds at a 2% yield in 1945 earned a negative real annual return of 2.3% over the following 35 years, according to the Barclays Capital Equity-Gilt study.

In America, Britain and Germany ten-year bond yields under 2% are now lower than the explicit (or implicit) inflation targets of their central banks. Well over half of British and American government bonds may be owned by investors who are relatively unconcerned about low yields!

The risk adjusted performance of more defensive and cautious asset allocated funds this year demonstrates that playing it safe and collecting income has been the better alternative for charity trustees who are looking for a steady course through the current economic turmoil.

Sadly, the old adage in charity investment is playing out. If trustees’ financial assets are no longer working for the charity at a rate far and above the rate of its expenditure, then they must reduce risk, cut spending or have a longer term horizon for their money.

While we can debate the merits of UK shares and their place in charity portfolios, or the risk of holding gilts over corporate bonds it is clear that asset allocation will always be the most important determinant of portfolio returns. Getting it right will depend mostly on the trustees financial needs and their attitude for risk.

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The burden of responsibility for trustees is increasing daily. The increased scrutiny combined with a low return equity environment and recessionary pressures on donations means many charities are faced with a bleak financial future. As Sir Donald Nicholls said in the Bishop of Oxford case, "Most charities need money; and the more of it there is available, the more the trustees can seek to accomplish."

So it is prudent to examine how those who manage and invest charities’ precious funds are conducting themselves. On examination what is evident is an investment industry, which while certainly not operating illegally, is regrettably in the main not operating quite as it should. Investment companies can sometimes be masters of opacity. Charities have to don a detective deerstalker and rummage around to uncover the truth about their investments – particularly in terms of costs.

Many investors simply cannot find out or understand how much their investments are truly costing, and as one charity trustee has been heard to complain, he knows the legs are being pulled from under him, but he just can’t find the information to prove it.

Small part of the total cost of investing

Most investors will know the Annual Management Charge (AMC) and maybe the Total Expense Ratio (TER) and understandably, but mistakenly, believe this is a true and full reflection of the total cost. But often it can be a relatively small part of the total cost of investing.

Even though the TER is meant to include some of the extra costs, e.g. custody and administration costs, performance fees, and the extra costs of any underlying funds, some managers do not include all the underlying fund costs and exclude performance fees in their reported TERs. Any dealing costs associated with the daily management are totally excluded as are many of the other costs.

As earlier as 2000, an FSA research paper found that in the UK only half the overall fees and costs were disclosed to investors. I have calculated that one of the largest hidden elements, dealing costs, is currently running at £2.7 billion pa in UK retail funds alone. Using the same assumptions, these costs would be £18.5 billion pa in the whole UK savings and investment industry. (I have used Morningstar data and Investment Management Association figures.)

The components of these dealing costs are: *dealing commissions: the price paid by the fund to the dealer for transacting; *stamp duty: tax paid on trades; *bid/ask spread; *market impact cost: the cost caused by the impact of a trade on the market for a security, e.g. a large fund may drive down the price of a security it is selling; *opportunity cost: the difference between the price at the time of the decision and the price obtained at execution that is not attributable to market impact. If a fund spreads a trade out through time to diminish market impact, opportunity cost can rise if the price moves adversely in the interim.

Impact of hidden dealing costs

The Investment Management Association (IMA) recently looked at the costs of buying and selling shares within traditional, actively managed UK equity funds. It found that the average reported cost of this dealing was 0.39% pa. However, its analysis only looked at the largest funds which as a function of their size normally deal less, and excluded the normal market maker buy/sell spreads which every fund manager faces.

When you adjust for these factors it is self-evident how much the hidden dealing costs amount to in an average fund – some funds may be considerably more and some considerably less.

How iceberg fees work

In essence, fund management fees can be seen as replicating an iceberg. Investors are shown the tip but rarely the whole iceberg; and it is often the part beneath the surface that can cause the damage. Fund managers’ iceberg fee scales tend to be highly complex with a myriad of fees lying below the surface. For example, some managers charge take-on fees, some charge for the custody of assets, or valuations and some inflated dealing commissions.

I was rather startled recently when I saw a press release from a large investment organisation announcing the launch of a special charity product with an attractive 1% annual management charge. The director of a foundation I am involved in telephoned and was told repeatedly that this was the only fee and it was "all in".

The company "forgot" to mention that the product was a fund of fund structure investing in other managers’ funds, the costs of which they had neither quantified or even mentioned in their advertising. The real cost was probably double the advertised rate.

New code of conduct required

My belief is that regulators and the industry should work towards a new code of conduct and ethics that will force the industry to reveal in one number the true cost of investments. The key is to work out ALL the costs and fees whether one-off or recurring, fixed or volatile, that come out of your original underlying investment returns so an investor can work out their "net" return. Accountants have successfully managed to achieve this for years by using firmly established principles.

DOES FEE TRANSPARENCY REALLY MATTER? Yes – in a period of low overall returns whether you are paying 1% or 3% pa, on underlying returns of 5% pa, can make a difference between keeping either 40% or 80% of the returns in your charity's pocket. Compounding has been described as one of the great wonders of the world – 2% compounded over 20 years is a staggering 49%!

Recently the highly regarded academics Dimson, Marsh and Staunton estimated that the real return on equities going forward was likely to be 3%-3.5% pa. If your charity is paying all-in costs and fees of, say, 2% to 3%+ pa, what is the point of investing? You could well be better off simply leaving your money in the bank.

Of course, costs are only one element, with risk and returns being the others, but only by properly calculating the costs can investors make truly informed decisions.

HOW WOULD IT BE POSSIBLE TO SAVE 2% PER ANNUM AS ABOVE? Consider the following and you should be able to do so.

Reduce investments in very high turnover funds – take UK equities for example, buying and selling a typical share including stamp duty, commissions and spreads is likely to cost 1%. So if your manager is turning over UK equities at 100% pa, which many are, it will be adding 1% pa to costs. Some managers use index funds to reduce these costs – using exchange traded funds avoids stamp duty completely.

Be very wary of traditional "fund of funds" – even if your manager is buying these funds at their special "institutional" rate, it is probably adding about 0.95% pa to your costs (assuming a typical 0.75% pa annual fee and 0.2% pa fund expenses). Some managers reduce these costs by either holding the securities directly or through low cost index funds.

Traditionally invested has been via funds but the more modern efficient method is via a managed account. Some managers offer managed accounts without charging the extra custody and administration costs, which often saves a further 0.2%.

Ask whether you are receiving anything extra by selecting a manager with higher costs to you?

Utilising the above actions can save as much as 2% pa. Of course this does not guarantee a good return – if the manager is investing in assets with little return then no matter how low their costs, you will still receive practically no returns. There needs to be a sensible balance between costs and returns.

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As a trustee reviewing a depleted endowment after some tumultuous years how should you assess whether you have chosen the "best" managers for your funds, or more importantly, whether they have been doing their best for you?

There is no doubt that 2012 finds many a nervous fund manager fretting prior to a meeting with charity trustees. No one likes to lose money for their clients but losing charity money is surely the worst. There has been no real total return from the UK FTSE All Share Index over the past 12 years. How depressing.

UK government bond yields dived to a record low last year and who was smart enough to buy these at the start of 2011? Not many. If you were lucky enough to have kept your rainy day money mostly in cash, did you manage to find a "high" interest account that produced a positive real return? Indeed, was your cash safe in the bank at all?

We could all be forgiven for wishing we had hidden it in the mattress. All the more reason then for trustees to reassure themselves they are receiving the best possible service from their manager under the circumstances.

Study the report card

Choosing a fund manager can be daunting. When conducting a "beauty parade", most advisors suggest that all those present mark the fund manager on a number of attributes ranging from presentation skills to the clarity of their investment philosophy. So how do you know whether or not you have made the right choice? After a poor year, do you fire your fund manager on the spot, regardless of previous record? Probably not. One bad year isn't necessarily a disaster but you do need to demonstrate that you have done your due diligence.

Like any sensible appraiser, I propose we study the report card, not only for the most recent term but over a reasonable timeframe to assess whether or not your fund manager is meeting your expectations. Consider the following criteria, marking each category and see how they add up. I have allocated a maximum potential percentage score to each criterion.

PERFORMANCE – MAXIMUM PERFORMANCE SCORE 25%. Did the portfolio produce the returns you expected or were they much worse (or better) than the trustees anticipated? If the returns were behind the agreed benchmark, how did the portfolio fare relative to the peer group? Was the performance achieved by taking the appropriate (and agreed) level of risk?

COMMENT. It is tempting and pertinent to award the highest marks for achievement or "outperformance", but performance must be measured with care and over a sensible timeframe. The new Charity Commission guidance suggests that trustees review their manager "from time to time"; most trustees interpret this to be once every 3-5 years.

Given the volatility we have witnessed over the past 10 years it might be wise to consider a longer assessment period. In the case of underperformance, trustees must be clear of the cause, be assured that any issues have been dealt with and importantly, won’t recur.

Consider a longer assessment period

INCOME – MAXIMUM PERFORMANCE SCORE 10%. How much income did the portfolio generate? Too much or too little, or was it exactly the amount the trustees had asked for at the start of the year?

COMMENT. Generating an agreed level of income from a portfolio can be a fundamental part of the manager's role. Achieving the correct balance between income for today's beneficiaries as well as allowing for future capital and income growth is arguably a charity manager's most challenging task. The dire combination of dividend cuts, depleted bond yields and dwindling interest rates come all too often hard on the heels of times of need, just when charitable grants are of the essence. To disappoint at such a time is a failing on the part of your manager and should be marked harshly.

Missing an income target

To lose capital value (although you may not have actually realised a loss) is unfortunate, but to miss an income target is careless and means disappointing a beneficiary. Conversely a portfolio might produce excessive income, possibly at the expense of capital growth: not quite such a black mark but still an unwanted surprise for the trustees. In short, trustees should rely on their manager to provide a steady income stream, or at least to communicate early if circumstances change.

IMPLEMENTATION OF POLICY – 10% MAXIMUM PERFORMANCE SCORE. Are you happy that your manager is investing the portfolio in accordance with the agreed strategy? Is the investment policy still appropriate or does it need updating? Should you consider another investment approach to complement your existing strategy? Absolute, relative or target return? Alternative assets, currency hedging, dampened volatility, socially responsible investment…have you considered all of these?!

COMMENT. The jargon can be overwhelming for trustees and every year it seems another, "better" way to achieve the perfect portfolio emerges. Whilst one should not dismiss new investments or alternative strategies straight off, it is probably best to start by reviewing your own Statement of Investment Policy to see whether it is still applicable.

Make sure that your manager is investing as the policy dictates, then discuss any changes you are considering. And if necessary, ask them to write a strategy paper assessing your overall investments and requirements. A good manager will pre-empt any matter that needs addressing.

The current investment climate will bring all number of challenges to which trustees and managers alike will need to adapt. Consistency is also imperative; try not to change your strategy too often as this can lead to the wrong decisions being taken.

STABLE ORGANISATION AND TEAM – MAXIMUM PERFORMANCE SCORE 10%. Is your manager part of a well established organisation? Is the team stable? Does the company attach sufficient emphasis to charities?

COMMENT. An ongoing, strong reputation for any financial company is clearly key. It is important however to ensure that the answers you sought and received when you first appointed your manager remain valid. A change of ownership is not necessarily a negative but it might mean that senior management's eye is taken off the ball for a time.

When there's an unhappy ship

An unhappy ship is made obvious by an unusual increase in the turnover of staff and this can quickly upset the balance within a team. Politics are prevalent in any firm, but if you do your research, you will be over halfway to finding out what is really going on behind the scenes. Make sure your manager is concentrating on your portfolio and not on his/her personal exit strategy.

COMMUNICATION AND PERFORMANCE – MAXIMUM PERFORMANCE SCORE 20%. How efficient is your manager and do you get on with them? Do you receive regular, clear reports and are they explained to the trustees properly? Could your manager be concealing a poor investment? Are they burying that all important figure?

COMMENT. First class administration should be an easy win but it is surprising how often that a failure in this department is the tipping point for losing a client. There is nothing more irritating than having to chase that all important report. Forming a close relationship with trustees is possibly one of the fund manager's most critical roles. It is a case of clear communication, confidence and trust.

Questions should be answered promptly

A strong rapport is essential and I don't mean that you should be wined and dined by your manager every week (don't worry, the Bribery Act has put a stop to all of that). Rather, you should feel that your questions will always be answered promptly and with the clarity they deserve.

During your meetings, ensure that the trustees can interpret the reports accurately and with ease. If you cannot understand something, chances are you are not the only one.

COSTS – MAXIMUM PERFORMANCE SCORE 10%. While we are on the subject of honesty, what about the fees you are paying? Are they competitive and what is the true picture?

COMMENT. There is nothing more frustrating than a trustee believing that they are paying much less for a service than they are in reality. Whilst we are all under pressure to reduce our fees there aren't many industries where there is still such a lack of transparency over the true annual cost of running a portfolio.

Even a recent survey of charity managers' fees resulted in a fictional report as a number of managers had not answered the questions correctly; not an encouraging outcome.

Yet it is very simple: any fund manager should be able to provide you with a summary of the total costs you have incurred. This includes all charges that are added to the quoted annual management fee such as broker commissions, administration, third party fund fees and VAT.

VALUE ADDED FOR CHARITIES – MAXIMUM PERFORMANCE SCORE 15%. So what is it that really makes the difference to our trustees? What helps them conclude after such a dreadful year that their managers are in fact doing their best under difficult circumstances.

COMMENT. The answer lies somewhere in a much over-used expression which is the "value added" that a fund manager provides. Not many firms, in my experience, devote enough resources to the charity sector. They might have their names up in lights as members of various charitable think tanks, but do they really have a presence?

Devoting resources to the charity sector

Charity fund management has always been a difficult beast to categorise, falling somewhere between the institutional and the private client. It is, nonetheless, quite different and should be treated as a niche area for all number of reasons. A credible manager dedicates a significant part of its business to charities,and offers regular charity seminars and trustee training.

Many charity managers write topical papers dedicated to issues that are facing charitable trustees: how ethical should your portfolio be? What is an acceptable and manageable level of income? How much risk should you take? How globally can you invest? All of these are valid questions and must be addressed and debated regularly if your manager is to attain the highest marks.

You are doing well if your manager scores 100% in the above test, but even a consistently high mark in each category with a 70%-80% result and they deserve to be in the top set for another year.

It is extraordinary to think that we are in the fifth year of the financial crisis. Five years is considered a reasonable timeframe to invest (and to make) money from real assets such as equities and property yet many of us, both trustees and fund managers, will feel uncomfortable as we evaluate our funds. Take comfort then from the last five or ten report cards and consider the above criteria as part of your review process.

Or perhaps I have just made a difficult subject more complicated and you pose one simple question to your trustees: "Are you sleeping at night?" If the answer is positive, then your managers are probably doing their best for you.

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