The past 18 months have been a rollercoaster for investment performance. Portfolio theory was proved wrong across the board as all classes of assets, from equities and bonds to property, hedge funds and private equity, fell in value.
The spread of assets made little difference, although diversification is still important for risk management. Investment professionals continue to be taught portfolio theory in their formative years, but it is time to let go of a theory that spectacularly fails every 10 years or so.
The Black Swan, Nassim Nicholas Taleb's book on the flaws of forecasting, is a must-read on this issue. Taleb uses the metaphor of the black swan to represent a totally unpredictable event. But stock market crashes and bank failures are arguably not black swans, because they happen fairly regularly.
Given this, it is useful to keep asking yourself some key questions. Why do you have investments? Are you looking for income, capital growth or both? How long is your outlook? What risks are you prepared to take? Do you want a modest absolute return or a larger return subject to greater risk?
The main risk for endowments and other long-term funds is inflation. Equities remain the primary means of preserving the value of funds against inflation. Holding equities for the long term now probably means 15 to 20 years, rather than the previous five to 10 years.
Holding cash used to be thought of as risk-free, but this has proved not to be the case. Moral hazard remains. It is still easy to be tempted by high returns from weak financial institutions and hope they do not fail or receive government subsidies. It is essential to read the fine print about liquidity to ensure you can withdraw money without incurring penalties, which can render the funds illiquid.
Fund managers, particularly of hedge funds, are not always able to justify their high fees. They are rewarded handsomely for making losses, and even more handsomely for making gains. Another moral hazard is that managers are rewarded more for the size of their portfolios than for investment performance. Rewards for volatility are higher than for steady performance.
There is a case for considering longer-term targets. Over 10 years, a manager who generates annual 10 per cent losses followed by 10 per cent gains delivers a loss of 5 per cent but is rewarded better than a manager who delivers steady 5 per cent annual growth and a gain of 28 per cent. We need to consider whether we are simply following the herd, and assess how much we are paying for the elusive value added by a fund manager over and above that achieved by an indexed fund. Common sense dictates that this added value amounts to less once you deduct transaction costs and the other costs of making investments.
If you have a balanced mandate for your portfolio, do ensure your investment manager is rebalancing sensibly. Otherwise, you could end up selling equities when stock markets are rising and buying them again when markets are falling.
With pension funds, you should be trying to match liabilities in relation to the age profile of your members. Actuarial analysis shows that for a pension fund with 50:50 bond to equity allocation, the riskiest element is, surprisingly, not equities but bonds, which have too short a duration. The investment strategy for pension funds should be very different from that of endowment funds or reserves. It might also be worth developing investment strategies for restricted funds.
If high inflation rears its ugly head, bonds will be a risky holding and cash will lose its relative value. However, if we have deflation, bonds will hold their own and cash will increase in value. Equities could fall again very rapidly as governments have to repair their balance sheets. None of us can predict the future, but we can make sure we are ready to respond and are taking risks knowingly.
A further challenge for international charities is the fall in the value of sterling. During the past 20 years, we could rely on sterling to appreciate against currencies in the developing world. Strengthened sterling also hedged against high inflation in developing countries. The international economic downturn and the rise of India and China might have changed that dynamic permanently.
Falling sterling and high inflation is a double whammy on the overseas purchasing power of UK charities.
Governance remains key. However skilled or experienced investment committee members might be, they need the right environment and information to take decisions. They need to be able to monitor the environment and act quickly when necessary, while also being prepared to stick it out for the long term.
- Rohan Hewavisenti is also a trustee of the Charity Finance Directors' Group.