Investment beliefs, most of which are implicit, guide the behaviour of every investor. However, Mark Weaver, Melville Jessup Weaver (MJW) principal, explains how trustees can save a lot of trouble by explicitly documenting their beliefs
Establishing a set of investment beliefs often seems like a strange and unnecessary exercise at the outset. But time spent on agreeing a set of beliefs will help improve the governance process by ensuring trustees make consistent decisions.
All the major funds, such as the NZ Super Fund, have a set of beliefs which they back up with statements, or proof points. For example the NZ Super fund has five beliefs which can be found here.
But trustees can’t simply cut-and-paste proof points from other organisations without serious thought and debate. Trustees need to negotiate a common agreement on what their investment beliefs are and how to express them.
However, as an example, this article will work through a set of beliefs that might apply to a trust.
In keeping with the overarching theme of this series of articles, we have put good governance as our first point of departure.
Belief 1 – Good governance will improve the chances of achieving good investment outcomes:
Essentially, we are saying that if we get the decision-making process right then the chance of good investment outcomes will increase. Given the huge uncertainties inherent in investment markets this has to be an easy one to get right. Of course in practice it can be difficult.
Belief 2 – Diversification of the portfolio will produce more consistent returns to an investor over time:
And the benefits of diversification apply at both the asset class level and within each investment sector. For example, trustees should consider, say, the diversification benefits of adding property to a portfolio consisting of just shares and bonds. Or what is the appropriate number of securities in a local fixed income portfolio – is five enough, or 30?
And it is possible to illustrate how diversification works with the use of statistical modelling.
The argument against diversification is one of ‘if you choose the right securities you will get the best results’. However, the ability to consistenly choose the best-performing securities is a rare, or perhaps non-existent, skill.
Belief 3 – Strategic asset allocation will determine around 80 per cent of returns:
This is clearly illustrated by comparing bond returns with share returns over time. The more shares a trust owns the higher the expected return over time – albeit the higher the variability of the returns.
After trustees have agreed on their objectives and risk profile, the first implementation decision will likely be how much to allocate to growth assets. A corollary to this whether trustees wish to vary allocations between asset classes over time – also known as, tactical asset allocation (TAA).
Trustees should tread with care in TAA territory but, historically many boards have skipped lightly over the issue.
There are many proponents who claim to have the ability to make TAA decisions. And perhaps the average trustee is willing to cede that investment professionals should ‘know’ better than them which way markets are heading and therefore TAA can work in their favour.
A note of caution is due here, however. While professional investors may happily reveal the instances when they timed TAA to a tee, trustees are unlikely to hear about the, probably much more numerous occasions, when the tactical call went awry.
Because of the difficulty of getting TAA decisions right, where a party is keen to make these decisions it is best to limit the scope. For example, if the investment adviser decides NZ shares are due for a correction, trustees could limit the TAA move to reduce exposure to that asset class by, say, 10 per cent rather than 50 per cent.
Of course, any TAA discussion should be sheeted back to the need for good monitoring to assess the quality of decisions made.
Belief 4 – There is a trade-off between the expected return and risk:
An investor who is looking for a higher return needs to be aware that there will be higher risk.
But it is also important to note that while higher-returning investments will be associated with higher risk, including greater variability of returns, increasing risk does not guarantee better returns.
Belief 5 – Efficient implementation:
Implementing an investment strategy in cost- and tax-effective manner will generate considerable long-term savings .
Adopting this belief will focus trustees’ attention on a simple way to add value and reduce unnecessary transaction and implementation costs.
The tax item is particularly interesting. There is potentially substantial tax leakage with NZ and Australian equities, for example, where a gross investor cannot access the imputation and franking credits.
On a fully-imputed dividend of 6 per cent an investor is going to lose 1.6 per cent to the tax man.
In contrast NZ bond yields provide the whole return to the investor. This is important to consider, despite evidence that the yield on these securities partly compensates for this adverse tax position.
Belief 6 – Selecting good active management will add value to a portfolio’s return:
There are frequent articles on cost advantages of passive management. Index investment strategies, together with the right asset allocation, can deliver good returns to clients.
However, some markets are more inefficient than others and represent better opportunities for active management – the NZ market stands out as an easy example.
In more efficient global equity markets, though, there are greater opportunities for an indexed approach. In NZ a number of firms may choose to manage their clients’ global share exposure with exchange-traded funds (ETFs), for example, while looking to add value by moving between, say, the health and consumers sectors.
When deciding on what strategy to follow trustees need to be clear on the reasons for their approach while keeping a close eye on the outcomes.
Without clearly-defined investment beliefs trustees have no firm basis on which to make decisions. But the beliefs themselves have to rest on the bedrock of thorough research and well-documented arguments.
However, like all good governance documents, a list of investment beliefs – no matter how well-articulated – should not be set in stone.
From time to time trustees should also review their beliefs to confirm they stack up against reality: if not, the dictum of John Maynard Keynes comes into play – “When the facts change, I change my mind”.