Lessons Learnt - 2013

As we progressed through 2013 some important lessons came to light. One centered on ethical issues, another focused on active versus passive management of investment portfolios, whilst the third provided some interesting analysis on portfolio volatility.

In this article we discuss the ethical, and active versus passive management approaches of investment portfolios and how we believe they are linked.
Panorama produced an interesting programme on charities.  They examined three charities from different perspectives and found them all wanting. One had paid excessive redundancy payments, much larger than contractually required, another had acted inappropriately when seeking corporate alliances, and the third, Comic Relief, had money invested in funds holding shares in companies conducting activities which were not at all in line with a charitable ethos.

Many charities find that pooled vehicles with a passive management approach (where funds are placed in a collective investment fund) is an easy option, particularly if the trustee board has little expertise in the area of investment management. These collective investment funds have a number of advantages:

    Risk is reduced by exposure to a widely diversified spread of investments
    Opportunities are available to invest in worldwide assets, shares and sectors that can be impractical and
       costly for a small portfolio
    Dealing costs are reduced
    Relatively small sums can be invested
    There is access to professional fund management
    Different funds can be indentified for different investment objectives, e.g. income or growth, or a mixture of

However they can also have significant shortcomings. 

Whilst it is possible to conduct an ethical screening exercise on collective funds, it would be a time consuming and very expensive exercise because of the wide universe of securities that are available for fund managers to invest in.

In addition, investment houses managing collective investment can choose only from baskets of investments selected by their fund managers, so that there is limited scope for your investment portfolio manager to perform tactical management during times of market volatility. He therefore does not have complete control of performance, or what is actually traded on your behalf. 

One client, a religious order, found that through the collective investment fund approach they had unknowingly purchased shares in an organisation well known for the manufacture of armaments. This was a very uncomfortable experience for the client, rectified quickly, but none the less not what they had expected.

When adopting a direct approach to the purchase of securities within your portfolio, the manager is in far more control of what is happening. Whilst the universe might not be as large, the ability to directly invest in different sectors and foreign markets allows sufficient diversity. With a smaller universe it is easier to perform both positive and negative ethical screening. Your investment manager has greater control over the performance of your portfolio.  He can tactically decide to move away from riskier assets during times of market distress, or equally decide to take profits and sell assets that have performed well in order to shelter profits. At the same time he can take advantage of opportunities where assets are undervalued.

With active management you have the ability to ensure your ethical policies on investments are adhered to in line with the charitable objectives, and the timing of when the your manager buys or sells holdings can be accurately controlled.

Another interesting issue cropped up during the year.  During a portfolio performance review we asked investment managers to propose alternatives to their collective fund approach.  Solutions put forward included those that would have delivered a better return over the period, had the client been invested directly from the outset. It does beg the question whether the investment manager would have offered to take more active steps to achieve a better yield, had we not requested a revised approach.

A further observation came as a result of undertaking some performance analysis across a number of managers. We found that those that had phased their entry into the market when building the portfolio had delivered more consistently and steadily during the investment horizon. Volatility was much lower than the big bang approach of buying assets all at once, whilst at the same time they delivered an improved return over the three-year time period.

It is clear that many investment houses favour the collective fund approach.  The portfolio managers do not need to be pro-active and, whilst performance might occasionally be bumpy, they feel confident that over the long term the results will speak for themselves, and, over a 20-year period they normally do.

The problem is that disregarding volatility can result in an emotional journey for the customer in the short term, say three to five years, and is often fraught with dramatic highs and lows. Whist the highs can be superb, the lows can be nerve wracking and in many instances the actual performance averages out to be similar or even worse than if volatility had been pro-actively managed.