After the dotcom fiasco... Changing investment issues for trustees

In the wake of the dotcom crash, it may seem easy to blame stock market volatility for a client’s financial losses. But JUSTIN A URQUHART STEWART argues that such excuses need to be replaced by a careful and planned approach to investment.

No one can deny the fiasco of the dotcom equity crash of 2000 and, of course, as a direct consequence, many suffered from the resulting destruction of investment value of the following two years. However, the usual excuses that are often given for such a financial disaster can be complex and I have grown fed up with listening to excuses from those who merely blame those unfortunate losses for their clients’ portfolios on the vicissitudes of a fickle stock market. Perhaps now is a good moment to reflect on what exactly we are asked to achieve by our clients and to revisit our responsibilities and obligations, both as investment managers and especially as trustees.

I feel very strongly that investment is, and always has, needed a strong process, structure and discipline. Investment is not about stock and fund picking which, while sounding exciting and dynamic, has all the reliability of betting on the next horse race. Investment is clearly a process: not a punt.

However, from this financial debris there has emerged an important report that sought to try and provide some extremely pertinent conclusions for trustees of pensions, charities and trusts: the Myners Review of Institutional Investment in the UK (2001). In this document, Paul Myners sought to set out a clear model of best practice for investment decision taking by trustees and provide some straightforward guidelines for trustees to follow. When the Trustee Act of 2000 is also taken into the equation, however, it becomes much clearer that there is a growing weight of responsibility resting upon the shoulders of trustees when managing investment portfolios and the associated decisions.

There are, in my view, some significant conclusions from the Myners Report, which I believe trustees should take account of. These key points also resonate within the Trustee Act as well, which of course has the added benefit of providing the force of law behind these issues. I think the best way to highlight these is by way of the points outlined below.

A focus on asset allocation

For nearly two decades the subject of asset allocation was the forgotten discipline when it came to investing. Research over the years has consistently shown that it has been the importance of being in the right asset classes that has been the overriding issue when it comes to longer term performance for investment.

Asset allocation was by far the largest contributor to the variability of returns, rather than the vagaries of trying to pick the next winning stock or fund, and trying to time the market. However, let me be clear, it is not that market timing and investment selection is unimportant – but if you are in the wrong asset class to start with, then the portfolio will have a problem.

Up until the year 2000, it had been the domination of the equity market and culture that held sway at the expense of many other asset classes. Sadly, it would appear that this fixation with equities led to much of the intransigence of investment managers as the equity markets collapsed. Perhaps this is one of the key reasons why Paul Myners has on occasion even referred to pension investment managers as being ‘amateur’.

If one looks at the primary asset classes of cash, fixed interest, commercial property, commodities and equities, it is the equities market that is the smallest – and getting smaller. The focus of course for many has been on primarily equities, due to the trading commission normally applied by many stockbrokers and private banks and, to a lesser extent, fixed interest investment, the result being that the pricing structure normally adopted actually works against an effective, broad asset-allocation process. Other asset classes need also to be included such as currencies, hedge funds and structured products as well as private equity for the higher risk portfolios.

There are two main reasons to use asset allocation. First is to manage volatility of longer term investments. For example, balanced risk portfolios with nearly 80 per cent in equities, if translated into volatility, could result in 60 per cent volatility in clients’ portfolios – if that is balanced, then I suspect the client might not be. Second, adopting asset allocation is to improve the predictability of returns.

There is a delightful quote from the well known economist JK Galbraith: “There are those that don’t know and those that don’t know that they don’t know.” I think all investment managers should have this sentence tattooed on them as a reminder; after all, nobody actually knows what will happen in the future.

Nevertheless, we do know how each of the asset classes has performed in the past and, thus, we can throw these calculations forward to try and anticipate future returns, even if some were to fail. Our task, therefore, is not to try and shoot the lights out, but to try and achieve what the trustees require under their mandate.

Explicit mandates

This brings me on to the next key issue for trustees: the requirement for trustees to agree an explicit written mandate with external managers covering a clear expression and definition of their investment objectives, the necessary benchmarks and the risk parameters of the portfolio. All too often, this seems to be missing or, even if defined, then it is quite often out of date. These mandates are supposed to be living vehicles reflecting the demands of the underlying trust document but needing to reflect that in the current investment market. After all, what may have been acceptable or achievable decades ago may now be wholly inappropriate.

An example of this could be social or environmental issues that the trust document may wish to take account of but when established, there were neither the investment means nor services available to take account of such requirements.

Additionally, what may have been unacceptable a few decades back may now be more suitable. A good example of this would be leisure businesses which may include restaurants and clubs but previously could have been seen as dens of iniquity. The mandate for investment needs to reflect these points but, under the Trustee Act, there is a requirement to ensure effective validity (that is, up to date) and especially that it should be tested against the investment structure to ensure proper compliance.

This mandate for investment policy has to be a written statement – and I would expect this to cover all the key guidelines from risk levels, time scales, income and capital requirements, and, of course, any ethical issues to be considered.

As for who should operate and offer such facilities, there must be effective evaluation of such providers, including the appointment of nominees, custodians and investment managers. Such selection should take account of their suitability by way of qualification and expertise. One point to note with nominees is that they need to be separately incorporated from the investment-management arm, have a written agreement and, particularly, a separate insurance/indemnity policy over and above the somewhat meagre statutory compensation limits.

Measurement, benchmarking and reporting

This is a fundamental section for trustees and is covered by both Myners and the Trustee Act. Portfolio measurement has in the past been a marvelous area for financial obfuscation where the investment manager or stockbroker has shown their power of imagination to explain away what may be ‘disappointing’ results. Myners is very clear in his views for total transparency of investment.

Whether in our pension schemes or trust accounts, there is no excuse for anything other than crystal clarity. The question of benchmarks has always been confusing and sadly I find the APCIMS benchmarks ineffective, as they reflect the equity bias of many such houses, resulting in an often gross overweighting in equities over other asset classes. The main point, however, is to ensure that a benchmark is demanded and performance is reported against it – and I would normally expect to see a nice clear graph rather than less comprehensible tall towers of numbers.

The question of reporting has of course significantly benefited from the impact of technology, where portfolios no longer have to be reported six monthly or annually but can be made available electronically each day over the internet.

Now, while most trustees may not wish to have daily access to such information, it must surely be better to easily and quickly interrogate such data as and when required. There is a further point that Myners highlights regarding asset allocation. It is that it must be an ongoing process, which changes and adjusts according to events, markets and circumstances, to ensure that portfolios are reflecting the aims and wishes of the trustees and, more importantly, not leading them to a position that may be of concern to their personal liability.

By way of example, a balanced portfolio from a private bank may have an approximately 80 per cent holding of equities, of which 60 per cent is in the UK. The rest is fixed interest and usually just UK bonds and gilts, with a small amount of cash. This is, in my view, a very narrow range of asset allocation but hardly changes to take account of market variations and changes.

Another example, however, may have a far greater depth of asset classes, including property, commodities, hedge funds and currency overlays, providing a far broader range of asset exposure and diversification. More important, though, is the variation and adjustment that takes place to take account of global markets, currencies and economies – in effect, it is alive and not just a seemingly dormant structure. It is a better example of an ongoing need to change and adjust asset allocation.

After the fiasco, I hope the investment industry has learnt from its failures, but it is with some regret that I think that may not necessarily be the case. Equity laden, commission-driven portfolios still seem to be prevalent and, as we have had three years of a bull market rally in equities since March 2003, many seem to have forgotten the issues of only five years ago.

Perhaps now then is a time to remind us all of the need for clear process, structure and discipline, and to ensure that the wise directions of Paul Myners are heeded and the Trustee Act is obeyed.

Justin A Urquhart Stewart is a director of Seven Investment Management, a division of Killik & Co, 020 7337 0527. He is a trained barrister and is a prominent commentator on all matters financial.