Wealth preservation: It all hinges upon management

In the current risk-averse financial climate, the defined objective of investment policy will very often be to match the liabilities of a charity with suitable assets.

Sometimes a mandate will be handed down to the investment manager in the form of an inflation-plus benchmark. 

Such a benchmark directs and measures investment performance against the Retail Price Index (or similar index) plus a real (post-inflation) return of, say, 2, 4 or 6 per cent, depending on the degree of acceptable risk. This is achieved by blending a spread of assets in the portfolio in a risk-controlled environment.

The aim is to create a solution that is likely to meet the charity's return criteria while minimising risk. Research has shown that the asset allocation accounts for more than 90 per cent of the investment performance, the remaining 10 per cent being a mixture of share selection, market timing and other factors.

The backbone of asset allocation is risk management. Different asset classes are appropriate for different economic stages and market conditions.

For example, if the economy is growing, equities may be appropriate.

If there is growth and deflation (or a risk of deflation), however, fixed-interest securities become more suitable. If the economy is contracting, index-linked stocks or absolute-return investments come into their own, depending on the state of inflation or deflation respectively.

Diversification is vitally important to ensure that returns are achieved without undue risk, given the investment objectives. The range of available asset classes has expanded hugely over the past 20 years, and today includes commercial property funds, absolute-return funds (also known as hedge funds) and, for larger portfolios, private equity stakes and structured and capital-protected products.

These asset classes have to be considered and evaluated relative to each other through financial models. Mean-variance optimisation programmes give the best return for a given level of risk, weighing up risk (expressed in terms of standard deviation), correlation (in other words, relative attraction to each other) and expected return (as based on the forecasts of the manager).

If all this sounds complicated, I'm afraid that's because it is. But the outcome should be steady progress without the nightmare of a sudden bear market wrecking the gains made in 10 good years and the agonising decisions that accompany such an eventuality.

• George Lynne is the new business director at PSigma Investment Management

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