Living in an absolute world
After 12 years of unusually volatile returns from equity markets, with little capital gain achieved it is no surprise that some trustees are seeking alternative and relatively unconventional approaches to secure the ‘real’ value and spending power of their charities’ assets over the next decade.
The new way typically revolves around a more active and judgmental style of investment, taking bold asset-allocation positions and seeking to avoid capital losses, thus producing attractive absolute levels of return with relatively low volatility and small drawdowns.
However, while many managers have set out to achieve smooth and attractive returns, few have produced presentable results. Moreover, who is to say that the few who have delivered the best returns over the past ten years will come out on top again in the future? This approach involves taking significant manager risk. Many of the absolute and target-return funds promoted to investors today have short track records, while others have generated their attractive return profiles from high allocations to bonds, an asset class that looks increasingly like an accident waiting to happen.
So while a successful approach over the past ten years might have been to appoint a target or absolute return manager (with the major assumption that you picked one of the few successful protagonists), it is doubtful whether this approach will produce the best returns in the next ten years. Equities should be the asset class of choice for long-term, endowment-type money in the period ahead.
This is supported by the returns from bonds and equities over the long term. In particular, it requires an understanding of the equity de-rating that has taken place since 2000. Indeed, since 1900 – a period that includes two world wars, multiple economic booms and busts, periods of deflation and inflation, and several waves of significant technological advancement, there have been only seven occasions when equities have not made a positive return over five years or longer.
A failure to understand the importance of income?
Much of the appeal of moving to a target-return style of investment can be found in the failings of the average charity manager to focus on the one element of investment that makes managing charity portfolios so different from other types of investor: income. History shows that income is less volatile than capital: according to the Sarasin & Partners Compendium of Investment, since 1926, when our records begin, the standard deviation of dividends in the UK is 10.4 per cent – less than half that of capital returns, at 23.2 per cent.
Sadly, income management and diversification strategies have too often played second fiddle to capital management in recent years.
This is perhaps understandable in private client portfolio management (who wants to receive lots of income and be taxed at 50 per cent when capital gains tax rates are so much lower?) and in pension and life fund portfolio management (where actuarially driven solvency ratios are so important).
However, it is surprising that so many charity investment managers have been swept into the same search for short- to medium-term capital volatility management. Might this be because the fees for target and absolute return portfolios and funds tend to be 30–50 per cent higher than for more conventional approaches, and often charge a performance fee?
A more plausible approach?
There is a strong case for placing the global search for sustainable income streams at the heart of an investment process. The global market for equity income has developed significantly in the past ten years – a development that had been missed by many investors until recently. Investors have, for some time, had the chance to invest in reliable global dividends, coupons and rents, thus diversifying away from UK equity income mandates that had become too dependent on the few stocks that make up such a large proportion of the overall UK market yield. Dividend concentration levels had reached such dangerous heights that combination punches of the banking collapse and the BP Gulf disaster left UK income investors, who had not diversified their income stream overseas, reeling.
An absolute-income investment style – and one that has been designed with charities and endowment funds in mind – may be preferable; with this it is necessary to monitor and manage income diversification as much as capital diversification. This offers trustees a relatively low-risk way to achieve long-term goals. Notably, it presents high levels of transparency and targets a plausible and prudent balance between manager risk and market risk. While concentration risks in the UK are lower than they have been recently, they are still high by international standards. From a growth perspective, international dividend cover is also higher than in the UK, offering prospects of better and more sustainable growth in these troubled times.
While an absolute income approach can result in some volatility of capital (and this can be tempered, within reason) it is realistic to expect between 75 per cent and 100 per cent of annual spending to be met by sustainable income. If you are confident that your regular spending is all or mostly met by income, does short-term volatility matter as much when compared to an approach that requires regular capital disbursements?
Measuring the results
Setting absolute income and income-growth targets does not mean forgetting about total return benchmarks: it is recommended that trustees use conventional indices to measure short and medium-term performance and the overall value the manager is adding to their portfolios. Also, this approach does not mean one should not target a certain level of absolute return: it is just that this should be a longer-term goal and not something to try to achieve every year. Ultimately, all portfolios should be designed with clear absolute and real target levels of total return in mind, and matched with a realistic timeframe for this return to be achieved.
The debate over the different styles of investment will run for some time. If you appointed an absolute return manager five or ten years ago, you are probably very happy with the overall results, if a little disappointed more recently. If you moved to this style of investment at some point in the past three years, you are probably feeling frustrated already. Looking ahead, it is doubtful whether the returns in three or five years’ time will make you any happier. For most charities and most trustees, an absolute-income approach offers the best chance for long-term success.
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