In the first of a series of five articles addressing trust governance issues, Mark Weaver, partner with actuarial consulting firm Melville Jessup Weaver, lays out the fundamentals for developing and investment strategy.
Rather than relying on ongoing capital injections from sponsors, most trusts want to back up their grant-making largesse with a strong investment performance.
But developing sound investment strategies – and investing practices in general – trusts need to institute rigorous review process, including benchmarking how their results stack up against other similar entities.
How do trusts go about setting an appropriate investment strategy?
The question is one of how to best manage the investments to first meet the trust’s stated objectives while achieving an appropriate return on the investments. The strategy needs to be not too conservative and not too aggressive.
Most trusts will have two guiding objectives:
- make regular distributions; while,
- maintaining the real value of the trust’s capital over time.
The first objective of giving money away regularly is really what the trust is there for. The second objective is about being able to continue making a consistent level of distributions over time having regard to the impact of inflation.
The challenge for the trustees is arriving at an investment strategy which strikes the right balance between investing for growth over time while maintaining a reasonably stable value of the portfolio in the short term.
At one extreme would be investing solely in NZ bonds, which will provide a regular income and a high level of certainty of the return of capital over time. Or at the other end of the risk spectrum trusts could invest solely in shares, which can be expected to produce a rising income but at the expense of significant swings in the annual value of the trust in the short term.
The chart below illustrates the point comparing the returns since January 2004 from a portfolio invested solely in the NZX50 and one invested in the A-grade corporate bond index.
The two portfolios produce different results. The value of the share portfolio fluctuates significantly while the NZ bond portfolio has a good steady performance but at the expense of weak long-term returns.
From late 2008 to early 2013 the bond portfolio saw better returns. So clearly some combination of the two portfolios will produce a more consistent result and the dotted line illustrates a 50:50 portfolio position.
Remember this is looking back, which is very easy.
But why would anyone choose the first strategy with the results showing lower longer term returns?
What we do not show is the income produced by either of the investments. If we showed this we would see a rising income on the shares while the bond portfolio income would be pretty constant.
Let me suggest that selecting the conservative bond strategy is completely understandable as the trustees will have just been cautious and will not have wanted to be part of a board that lost capital.
But another person looking at the outcome might choose to criticise the trustees for being too conservative and might say that the difference in end values could be considered lost capital.
So how do trustees arrive at the right investment strategy? Unless they are all experts in their own right they are going to need to take advice.
And even where they are experts it can be easily argued they still need to take advice as this will assist them in arriving at the right strategy – as experts they will just be in a better position to evaluate the advice they are getting and so ensure they are doing the ‘right’ thing.
Considering the results of statistical modelling for different strategies can assist the decision-making process. At its simplest level it will illustrate the relative outcomes of the two portfolios we have discussed above.
But the models only provide part of the picture as there will be other risks the trustees need to be aware of. For example, credit risk and holding a bond portfolio with some lower grade debt that is only going to provide limited capital stability in the event of a market reversal. Witness the GFC.
Looking at different scenarios will help to better understand how the portfolio will perform and will assist trustees to make better decisions.
And having gone through a proper, fully-documented strategy review process the trustees will be better able to address concerns from interested parties if the trust does suffer a period of poor performance.
Another way to look at the potential outcome from different portfolios is to look at how they have performed in the past over different periods of time. Arguably it is easier to look back at the past for this comparative analysis.
So in summing up we would argue that it is important for trustees to carefully evaluate different investment strategies for their trust.
The key point is that it is probably too easy to play it safe by choosing a conservative strategy. It would be better to look at other strategies, fully understand the risks of each strategy and then make an informed decision.