The Investment Research Partnership

Controlling investment risk -

A guide for Trustees

Published in STEP Extra June 2005

Trustees are coming under increasing pressure to ensure that they are seen to be managing assets under their control in the most effective manner. The control of risk is a key feature in this task and we attempt here to look at the quantification and control of investment risk in the management of trust assets.

Analysts have a variety of technical means to measure risk, and whilst these may be of some use to trustees, they will usually have delegated specific responsibility for the management of trust assets to one or more investment managers. The management of investment risk for trustees therefore relies on adequate assessment of the needs of the trust and clear direction to the investment manager as to what these requirements are. Once these have been established, regular monitoring of the investment manager’s performance in relation to these requirements should enable trustees to meet their obligations and ensure that trust assets are managed in line with their stated goals.

It is a requirement within the UK Trustee Act 2000 and it is expected in other jurisdictions that Trustees construct investment policy statements when delegating the portfolio management function.

The main purpose of the policy statement is to set the guidelines and conditions under which the trust’s portfolio is to be delegated and managed. If the trustees’ requirements are stated clearly and concisely in this document, the investment manager will be able to develop and implement a strategy that will fulfill the trust’s specific objectives.

The key points required of a good policy statement can be defined under five separate headings; Aims and Objectives, Particular Preferences and/or Constraints, Risk profile and Time Frame, Asset Allocation and Benchmarking, and Ongoing Reviews and Reporting. Identifying and confirming each of these areas will ensure that the appointed investment manager is fully aware of the requirements of the trust and that the trustees are able to demonstrate that they have complied with the legislation.

With each of these areas covered in the policy statement, the trustees will have made positive statements as to the degree of risk to which they are prepared to expose the assets of the trust and put in place procedures to ensure that the risk profile is controlled according to their requirements.

Aims and Objectives

The aims and objectives of the trust need to be clearly stated and where appropriate this should include specific goals. Often the trust objective may be defined as “capital growth” or “income and growth.” Whilst this definition offers some guidance, a more specific statement will be of greater assistance in devising an appropriate investment strategy. For example, “capital preservation with growth” clearly identifies capital preservation to be the key requirement with additional growth being achieved without undue risk to the capital value. Similarly, identification of a requirement for capital growth with a view to providing a lump sum in fifteen years would be helpful to the investment manager. Further clarification of any constraints and confirmation of the required risk profile will be covered within the investment policy document and will offer a clearer picture to any investment manager seeking to put together a portfolio which will meet with the trust’s requirements.

Particular Preferences and/or Constraints

Each trust may have individual requirements not automatically identified under another heading. This might include details of the type of trust, a need to balance the needs of different classes of beneficiary, any ethical, geographical or sector constraints, specific income or capital requirements or any tax issues that may need to be accounted for. Providing the investment manager with as much information as possible will undoubtedly leave less scope for misunderstanding and offer the greatest opportunity for success.

Risk Profile and Time Frame.

The standard industry investment definitions of risk as “high”, “medium” or “low”, are somewhat ambiguous and it is clearly important to ensure that both the trustees and the investment manager have the same interpretation as to their meaning in relation to the risk profile of an individual trust. Where possible it may be appropriate to include maximum loss tolerance or an expectation of annual growth requirements.

Minimising downside risk is a key but rarely highlighted aspect of risk management. Building in an effective stop loss will reduce the potential loss not only at outset but on an ongoing basis if the stop loss is adjusted to lock in previous gains. This adjusted stop loss level would need to be reviewed on a regular basis or, for example, when a gain of 5% or more has been achieved. As the value of the portfolio increases, this strategy would ensure that some of the gain is preserved on an ongoing basis whilst still allowing the investment manager scope to achieve significant growth on the investment.

The time frame appropriate for an investment portfolio may be influenced by a number of factors. Equity investment should only be considered for portfolios with an investment term of at least five years and generally should be considered longer term investments. Specific requirements such as the timing of any future liabilities, liquidity requirements, requirements for capital and income in the short, medium and longer term should also be identified as these may have a significant impact on the way in which the trust assets are managed.

Asset Allocation and Benchmarking

Depending upon some of the other goals stated in relation to an investment portfolio, trustees may wish to state a specific asset allocation requirement. For example, an asset split of 40% UK equities, 25% International equities, 30% fixed interest and 5% cash. Alternatively, they may wish to offer the investment manager a degree of flexibility by stating minimum and/or maximum allocation for each asset class.

Providing confirmation of the acceptable range of different asset classes or sectors within the portfolio will enable the trustees to have some degree of control over the risk profile.

This section should also outline any benchmarks to be used in conjunction with the portfolio. Benchmarks provide some measure of investment performance as well as demonstrating that trustees are performing their duty of care.

Benchmarks set in conjunction with a portfolio’s objectives and risk profile help to influence the type of assets included (and not included) in the portfolio. In different situations the portfolio may represent the entire trust assets or perhaps only a proportion of them. The benchmark selected for a portfolio which represents only the equity holding of a particular trust will be very different from the one suited to a portfolio which holds the entire trust assets. In the case of the former, an equity benchmark would perhaps be selected with some consideration given to the preferred geographical split, in the latter, some consideration would need to be given to a combined asset split of cash, fixed interest and equities as well as a preferred geographical split.

Benchmarks should be used intelligently as a guide to investment performance and asset allocation and not as an end in themselves unless specified as part of the portfolio objective.

Reviews and Reporting

The periodic reassessment of a trust’s investments is central to the trustees’ duty of care. It is essential for the trustees to review the success of the trust investment portfolio in meeting the stated aims and objectives. Regular and preferably independent reviews of portfolio performance against a benchmark offer manager accountability and provide a paper trail of active review.

These reviews would normally be carried out quarterly or, at the very least, half yearly and will offer the trustees the security of knowing that if their objectives are not being met they have plenty of time to take action before the situation spirals out of control. Even where objectives are being met, it is important to reconsider the choice of investment manager on a regular basis with the suggested time frame for such reviews being in the region of every three to five years.

With these headings as a guide, trustees should be able to produce a comprehensive investment policy statement. This will provide a valuable link between the investment manager, the trustees and the beneficiaries. It ensures that all parties understand precisely the requirements of the trust and its objectives and acts as a blueprint for ensuring that these objectives are being met. In particular, for the benefit of the trustees, it fulfils the initial duty of care requirement and helps put in place procedures for regular review and the long term monitoring of the portfolio.

Trustees’ obligations to manage trust assets according to the requirements of the trust mean that they do not have an option to minimise risk by retaining all the assets on deposit if there is a requirement to achieve capital growth over time. The control of risk is therefore a key issue for trustees who must aim to manage trust assets in such a way as to meet the trust requirements without exposing the assets to an unacceptable degree of risk.

Regulatory authorities in many jurisdictions are bringing in legislation to ensure that trustees have adequate frameworks in place, not only to fulfil their obligations but to be able to demonstrate that trust assets have been managed to the best of their ability.

It is essential that trustees have a system in place to select investment managers who are able to manage the trust assets in line with their requirements, a clear investment policy statement to outline their objectives, risk profile and other issues relating to the management of trust assets and ongoing monitoring procedures in place to ensure that their requirements continue to be met.