August/September 2011 Investment Analysis: Reaching the target

Written by Philip Smith and Malcolm Herring
August/September 2011

Target return funds are about being in the right assets at the right time, and being out of assets when they are not performing. Philip Smith weighs up the evidence for charities to take the plunge

Last quarter the UK economy grew by a derisory 0.2%. The US budget crisis will, many believe, deepen following that nation’s top triple A rating being downgraded with huge knock-on effects across the global, or at least western, economies. China is far from a safe haven: it’s debt now runs at 200% of its GPD and inflation is a growing concern.

The Eurozone continues to stumble from bailout to bailout and economists and politicians alike are forewarning of an economic ‘tsunami’ heading our way.

Whatever the accuracy of such predictions, it hardly creates the conditions for charities – or anyone – to make long term investment decisions.

But that’s what we have to do. For charities the burden is greater. Not only do investments have to generate income and protect capital, but risk has to be justified and trustees cannot play fast and loose with the funds.“Trustees have to monitor and be accountable for the performance of their portfolios,” notes Malcolm Herring, director of charities investment at Barings.

Right assets
One option offered by fund managers is that of target return funds. They do as they say: they have a target return which is typically set at so many points above inflation. To achieve such a predefined rate, fund managers use a range of traditional asset allocation methods – investing in equities based on geography (overseas and UK) and sector stock selection (banks, retail etc) as well as other avenues such as bonds and cash.

“It’s about being in the right assets at the right time, and more particularly being out of assets at the right time when they are not performing,” adds Herring. Barings’ Targeted Return common investment fund aims to return growth of 5% above the Consumer Prices Index (currently 4.2%) over a rolling three year period. And, says Herring, it has so far achieved that target. “It’s all about reducing levels of volatility and defending values in difficult times,” he adds.

It requires actively switching funds between asset classes in readiness for expected drops. “We actually reduced the equity rating of our funds last May because we were very nervous of the prospects for the Eurozone. We thought there would be a crisis of liquidity and the policy response might be muddled and that’s what’s happening,” he says.

Achieving return
So the plan is that the targets are reached irrespective of market conditions, while limiting the risk of capital loss. Sound too good to be true? Well, there are some downsides. The main one being few have actually achieved their target return, said Charles Gowlland, an investment director at Smith & Williamson, an investment management company with £10.5 billion of assets under management, of which 8.19% belonged to charities.

“Most of these target return funds were launched in the mid 00s when the world was quite different,” adds Gowlland. In short, when the going got tough, targeted funds failed to live up to the hype. “A lot of fund managers will say these targets are over a rolling three year period. But these funds have now been running long enough for their original objective to be validated or not. And by and large they have not done what they set out to do.”

Barings may be the exception. It’s Common Investment Fund saw returns of 22.2% in 2009 (target 7.28%) and 13.89% in 2010 (target 8.4%). One reason why some such funds may have failed to live up to the hype is because they were over complex, said Herring.

“There’s a wilful naivety in simply handing over money and expecting to receive a target return,” says Gowlland. “Those buying these funds might be guilty of willingly deceiving themselves over what is practical, achievable and desirable. Everyone would love to get 7% year in, year out, but the world doesn’t work like that. There is a huge gap between realistic outcomes and investor expectations. In this unusual but testing environment these funds have been found wanting.”

Herring agreed that investors need to be aware. “It’s important, when thinking about the targeted return you are aiming for, you should also think about the level of risk you want to take on,” he says.

Gowlland is not alone in thinking many who opted for such policies may have been left feeling less than satisfied. Tim Maile, head of Charity Investment Management at Quilter, a wealth manager with £7.8bn in funds under management, £500m from charities, said: “The targeted expectations are perhaps a little unrealistic. With any investment you have three basic components: return, risk and time. With targeted returns you find that if they don’t deliver in the shorter term then people are disappointed.”

Having a plan
With such a negative image among some in the industry, why are targeted funds still being followed? Could the Barings’ fund be a flash in the pan? The appeal comes from trying to generate a predictable level of income. “Charities do need to plan as they have levels of expenditure that need to be covered so it’s natural they are looking for some degree of certainty,” adds Maile.

It’s certainty that is the underlying driver, especially in turbulent times. According to Maile, targeted funds tend to become more popular when conditions become more volatile. “They are good when market conditions are poor and volatility is high but they do not do well and are not perceived as attractive when markets are behaving normally. There is fashion for them when we go through periods such as we are seeing now.

“They are aimed at charities who may not have a full understanding of what investment is all about. The feeling is that a targeted return is something you can rely on and which is going to be produced over a shorter time period. But that’s just not the case.”

Maile advocates caution for any charity looking to follow a targeted return fund because of the unique added component that exists for many charitable investments, such as limitations as to where funds can be placed based on ethical and mission-led requirements. “Achieving a target return is hard enough in the short term. If you are then going to say ‘we won’t allow you to invest in particular sectors of the equity market or asset classes’, it will be even harder,” he said.

So, with uncertainly over bonds, low interest rates, stagnant property markets and general volatility in commodities, where should a prudent charity look to place its donors’ money? Are there other inflation-busting, targeted return strategies that could be adopted? Yessays Charles Fotheringham, head of Investment Management at Gillespie Macandrew, a Scottish law and finance partnership that offers range of advice to clients including charities.

To a degree any investment plan has a target, and selecting the right one comes down, he argues, to understating where we are in an economic cycle. Such products include fixed income strategies in which the capital is only at risk if the FTSE100 falls by more than 50% over the five years, and where you can currently get a return rate of 6%, he said. “It’s about as comfortable a way of investing as you can get right now.”

Another are ‘kick-out’ plans. These are also based on the FTSE performance where investors will see their capital returned with a 10% annual dividend if the market closes higher on the target date than the day the plan was started.

A further option are exchange traded funds. These again are based on stocks, commodities, or bonds, but traded on a day-by-day basis. They can offer some protection if the markets go down but do require constant professional trading and that may deter many charity trustees, said Fotheringham. “Often charities don’t like their account to be professionally trade. They don’t like too much activity. A lot are still very traditional.”

Another example, he said, is the Morgan Stanley UK inflation-linked income plan, a five year structured investment plan linked to the performance of the FTSE 100 and UK Retail Price Index. It offers 5.25% at the end of year one, followed by further potential annual payments of 1.5 times any potential growth in the UK inflation rate. “To me these are target returns,” he said.

It’s proof that shrewd investors do have options to see real growth even in volatile times. But it requires a greater awareness. “Charities have to be educated in risk investing,” said Fotheringham. “This is something a lot haven’t been doing over the past 20 years. It’s a very tricky market for charities at the moment, that’s why the structured products are good for them.”

“In everything there is an element of risk,” adds Maile. “You don’t get the return unless you have volatility. If you need to control the volatility you are going to get a lower return. There is no investment that is guaranteed nowadays.”

Philip Smith is a freelance journalist

Targeting investment

Malcolm Herring shows how a targeted return approach seeks to achieve real returns on a consistent basis and traditional benchmarks are put to one side

Market volatility is back on the agenda in a significant way, whether with fringe Europe and its ongoing sovereign debt troubles, or in the US, which is facing the possibility of a return to recession following sluggish economic growth numbers and indecisiveness from its political leaders. Distressed markets and heightened risk means finding the right investment solution for charitable organisations has never been more crucial.

Over 100 years of either UK or US history have shown that investors can expect to be paid about 5% over the rate on a risk-free bond to hold equities1. But there have been several periods of considerable volatility and absolute loss.

In our view, hope resides in an investment approach which not only focuses on absolute returns, but also on the risk taken to achieve those returns, so that they are delivered to investors as consistently as possible – vital if you depend on your investments for income.

In this respect, a targeted return investment approach could fit the growing needs of charities and institutional investors seeking income from their long-term investments but without having to judge performance against an index such as the FTSE 100 or a peer group such as the WM charity peer group.

A targeted return approach seeks to achieve real returns on a consistent basis so traditional benchmarks are put to one side. Instead the investor decides with the fund manager what they actually want to achieve – so a target return. This becomes the investor’s investment objective; thereafter the onus of decision-making is shifted to the manager.

The target return approach offers several powerful advantages: it is transparent and easy to interpret; it is forward looking and it gives the fund manager the flexibility to invest in whichever assets – both traditional and alternative – that they think are most likely to achieve the end objective. Above all, it is designed to achieve the aims of the charity and not to follow the herd.

Once upon a time it would have been adequate to follow a relative benchmark and be secure in the knowledge that your money was safe.

For example during the 1980s and 1990s, there were few negative years as markets reacted favourably to supply side reforms and to the gradual reduction in inflation. The increasing correlation between assets seemingly rendered active asset allocation obsolete; instead, the practice of following a benchmark seemed entirely rational.

But index benchmarks such as the MSCI encouraged fund managers to put money into markets that had already out-performed – as happened in June 1999 when the US equity market accounted for 62% of the MSCI World index – just before it collapsed. Also, established global equity indices tended to ignore emerging markets.

Peer group benchmarks, based on the average asset allocation of a particular set of funds, such as the WM charity peer group, have also proved popular, but their use leads to herding - the portfolio follows what everyone else is doing but might bear no relation to a charity’s own requirements or risk tolerance.

In fact one leading investment consultant, Towers Watson, has argued that benchmarks “have accentuated short-termism and have at times stifled creativity”. The consultant considered that the use of benchmarks led to “quarterly relative returns being scrutinised in detail and this short-term perspective produces two problem areas: Discouragement of the use of contrarian investment styles; and unnecessary levels of turnover in portfolios2.

Historically charities have simply split their portfolios between bonds and equities. While the returns from this strategy may appear satisfactory they come with significant fluctuations. A key study by the Institute of Philanthropy indicated that "some organisations are operating in a 'comfort zone' by taking familiar investment decisions rather than pro-actively seeking to implement potentially more profitable and more diversified investment strategies".

The same study found that those charities with more diversified portfolios realised returns of 0.9-1.6% higher than those whose portfolio contained 60% or more in equities between 2002 and 20073.

The example of the Yale Endowment is instructive: in 2010 it had 19% in hedge funds; 33% in private equity, 28% in 'real assets' i.e. oil and gas, property and timber, but only 20% in bonds and equities. It achieved a ten year average return of 8.9% versus 3.3% from a 60/40 allocation to US equities and bonds4.

A charity’s investment asset allocation should reflect its objectives and requirements, not the average allocation of a peer group of funds. Therefore we believe that asset selection skills – Barings’ core competence – will be the most important determinant of portfolio returns.

Malcolm Herring is director of charities at Baring Asset Management

1 Barclays Equity Gilt Study 20102 Remapping our investment world, Towers Watston (formerly Watson Wyatt), October 2003
3 "Investment Matters: in search of better charity asset management", Institute for Philanthropy, April 2008
4 The Yale Endowment Study, Yale University, 24th September 2010

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