Investment management: The Law of Averages

Mesquita says that trustees, many of whom may not be investment experts, should not allow fund managers to get away with arcane presentations that do not easily explain performance.

"It's important for the investment manager to present information in a clear way so that it is understandable for lay trustees." He adds that it is important for trustees not to feel shy about asking the obvious questions. "If trustees do not understand something they should ask the investment manager to explain it and if they still don't understand it they should ask for it to be explained again."


George Urquhart, performance and investment consultant at WM

Research organisation WM Charity Service divides the charity investors it works with into three groups - those that are un-constrained in how they can invest; those constrained by income needs; and those constrained by asset mix.

By producing regular reports on the investment performance of this universe, the WM indices allow charities in similar positions to compare themselves with their peers. Traditionally, most charities that have had a benchmark have measured themselves against WM, but today the majority have a customised benchmark, says Urquhart.

But he is relaxed about this trend: "Many people think WM supports peer group benchmarking, but we're simply trying to give an indication of what is happening in the charity investment world.

"Many of our charity clients have a customised benchmark, but they also want to know what's happening with their peer group," says Urquhart: "So they may ask us to provide two analyses for them, which means more income for us than if they were simply benchmarking against their peers." Even though the number of charities with a peer group benchmark is declining, he says that WM will continue to produce a universe of charity funds that allow people to track the performance of the sector.

"Even though most pension funds now have customised benchmarks, we still produce a universe of those funds to show what is happening in the industry as a whole," he says.


The Guy's and St Thomas' Charitable Foundation, linked to the London hospital of the same name, changed its investment benchmark a couple of years ago.

"We used to use the WM unconstrained funds, but then we decided to change our asset allocation and that meant we needed a customised benchmark," says finance director James Varley.

The main changes to the portfolio were to include new investments such as hedge funds and private equity, as well as a reduction in the proportion of the fund held in UK equities and more investment in overseas equities.

"This new asset allocation made our fund very different from the WM unconstrained, which is much more biased to UK equities," says Varley.

The charity uses several different fund managers for different elements of its £300m long-term portfolio.

Following advice from an investment actuarial firm, the charity drew up a new benchmark using a variety of indices.

"We still use WM to produce all the statistics for us and give us a commentary on the consolidated performance of the portfolio," he says.

The charity has an annual investment meeting with its actuaries, he adds, when the benchmark is re-assessed and may be tweaked to match changing market conditions.

With the ethical restrictions on some charitable funds, it can be misleading to compare performance with general trends. Patrick McCurry finds out how tailor-made benchmarks can help out.

Getting a good return from investments has always been a priority for charities. But the methods with which they measure investment performance has been changing in recent years, with a general move away from comparisons with peer-group performance to the use of tailor-made benchmarks.

Benchmarks are important because they mean a charity can find out not only if their investments have produced a return, but also if that return is better or worse than the charity average or relevant investment indices, such as the FTSE-All Share, which measures UK stock market performance.

Ten or more years ago, many charity investment portfolios did not have a designated benchmark at all, explains Richard Maitland, a director at fund manager Chiswell.

"At that stage, many were deciding to have benchmarks and usually chose a peer-group benchmark to measure themselves against, such as one of the WM Charity Universes.

"Today, most charities with long-term investments use a specific benchmark and an increasing number are choosing tailor-made benchmarks," he adds.

A peer-group benchmark enables charities to measure their performance against an average of charities, while a customised benchmark means that the investor is comparing its performance against a cocktail of market indices. These may include a UK equity index, a gilt index and others measuring different elements of the portfolio.

The leading provider of peer-group benchmarks is the WM Group, which divides its charity "universe" (the set of investors from which a statistical sample is taken) into charities that have no investment constraints, those that are constrained by income and those constrained by asset mix.

The WM universe collates the performance of some 280 charities but it is shrinking, and thus, according to some, sending out less representative signals.

Charles Mesquita, charity specialist at fund manager Carr Sheppards Crosthwaite, says peer-group averages such as WM can provide charities with "a marker in the sand" on industry-wide performance.

"Peer-group averages are not necessarily wrong but their appropriateness depends on the circumstances of the charity," he says.

Ethical constraints

Those for whom peer-group comparisons are probably inappropriate include charities with significant ethical constraints and those whose asset allocation does not reflect that of the WM average.

Chiswell's Maitland says that WM's averages of charities constrained by income and by asset mix are less representative these days because of falling membership, but that the unconstrained group is still used by many charities.

He adds that many charities that are not officially part of the WM unconstrained universe, perhaps because they choose not to pay for the service, but nevertheless use it as a benchmark.

The key thing, says Maitland, is for each charity to come up with a benchmark that reflects its specific investment objectives: "Benchmarks can vary hugely between charities, with some being very equity-based in their investments, while others are biased towards bonds."

When looking at how they will measure their investment performance, the first step for charities is to establish their investment objectives.

This will depend on how much income they will need in the short and long term.

When a charity knows its income needs it can then, in consultation with an investment adviser or manager, put together an asset allocation for its portfolio. This means what proportion of the fund will be invested in UK equities, overseas equities, bonds, and so on.

George Urquhart, performance and investment consultant at WM, says: "With the volatile stock market performance of recent years, many charities are going back to basics and asking themselves what they are trying to achieve with their investments - what their time horizon is and how much they can set aside and invest for the long term."

He argues that most customised benchmarks sit fairly well in the WM unconstrained group because the asset mix of the majority of charities reflects that of the WM average.

On the other hand, one of the disadvantages of peer-group averages is that they tend to follow the market and may not reflect wider changes in investment approach.

Maitland says: "A lot more charities are investing in new areas, such as hedge funds, and property is enjoying something of a renaissance. These asset classes are much more common in customised benchmarks, whereas peer-group benchmarks tend to have a historical bias."

This can mean that charities using a peer-group benchmark feel obliged to buy into the asset mix of that average and may, therefore, miss out on the benefit of changes in investment fashion.

"On the other hand, it can be an advantage because it means a charity is unlikely to rush into a new form of investment that hasn't proved itself," says Maitland.

There are also potential drawbacks of using a customised benchmark. These include the fact that it is difficult for a charity to know whether it might have done better with a different investment manager because that would require some kind of peer-group comparisons.

Coming up with a benchmark will depend greatly on the individual circumstances of a charity and it can be much easier for some charities than others to predict their income needs. For example, a charity that depends on legacies may not be able to accurately predict its income and, therefore, cannot be sure what income it will need from its investments.

Another challenging area is ethical investment. Because a charity with ethical constraints may not be able to invest in the whole of the stock market, it can be harder to find a benchmark.

"Ethical investments can be tricky because you may find you're restricting certain elements of the portfolio," says Carr Sheppards Crosthwaite's Mesquita.

Indices divergence

Of course, it will depend on the extent of the ethical policy. A charity that just excludes tobacco stocks may only be out of 2 per cent of the stock market but if it is also excluding arms, alcohol and other sectors the portfolio will be much less reflective of the main stock market indices.

Maitland says that in some cases, a charity with wide ethical restrictions may end up with a customised benchmark within a customised benchmark.

"For instance, a charity with a particularly rigorous ethical criteria could end up heavily invested in technology companies, so the trustees might well require a more appropriate benchmark than a standard market index."

Jocelyn Lynch, managing director at independent financial advisers Horwath Clark Whitehill Financial Services, argues that it is important for charity investors to break down their investment performance in order to get a clearer picture.

When looking at how the investment manager has performed over, say, a five-year period, it is important to drill down into each quarter's performance, she says.

"Analysing quarterly performance allows you to see trends that you might otherwise miss," she says.

For example, an investment manager could show a good return at the end of a year, but by analysing quarterly performance it could turn out that performance was poor in the first three quarters and then rescued by an unexpectedly good performance in the final three months.

"If an investment manager is pulling rabbits out of the hat to push up annual performance, it might suggest he is taking risks that the charity may not be comfortable with," says Lynch.

She adds that analysing quarterly performance also reduces the risk that charities will allow their investment managers to bamboozle them with statistics and obscure poor performance.

When all the other elements of assessing investment performance have been put in place, such as working out objectives, asset allocation and benchmarks, it is still vitally important for charities to question investment managers if they don't understand something.

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