Gold Core

The matters Trustees should consider in the selection of an investment strategy and the appointment of an investment adviser.

“The purpose of the order before the House...is to give trustee status to the shares of Allied Irish Banks Limited....The main qualifications for trustee investments are that they should be secure and give a reasonable income to the beneficiary. The shares of Allied Irish Banks fulfil these criteria and they are a suitable security for inclusion in the list of authorised investments.” Minister for Finance Charlie Haughey in the Seanad Éireann December 1969
One of the greatest challenges facing Trustees over the years has been the need to invest trust capital so that they address this classic dilemma of seeking to find a balance between the potential for investment returns and a prudent approach to capital preservation.  Equally, the challenge facing legislators has been to draft legislation so as to provide a suitable legal framework for Trustees to operate within.
Ireland has for many years looked to the UK as a form of “legislative laboratory” often seeking to borrow the best elements from English Jurisprudence and with this in mind this paper also draws on both legislation and case law from around the world. We also examine the global evidence from leading academic studies which consistently show the failure on the part of traditional asset managers to deliver investment performance commensurate with their costs and conclude that Trustees should not take the marketing claims of established fund managers at face value. Given the magnitude of the failings on the part of traditional fund managers, we would recommend that all Trustees are made aware of these findings and presented with the opportunity to review their current choice of investment adviser.
In Ireland today, Trustees are still substantially governed by legislation dating back to the Trustee Act of 1893 with only relatively minor amendments since then. The Law Reform Commission proposed a draft Trustee Bill at the end of 2008 and following the experience from the UK and the Trustee Investment Act 2000, is suggesting moving away from prescribing suitable investments for Trustees to emphasising the need for pursuing suitable investment strategies.
The Law Society recommend that the duty of investment and the appropriate standard of care for trustees should be codified in statute consistent with the principles of prudential investment (i.e. suitability, risk, diversity and appropriateness) on the basis that subject to a contrary intention in the instrument creating the trust, trustees should have the same power to make an investment of any kind as if they were absolutely (or beneficially) entitled to the assets of the trust. This duty of investment and standard of care they feel would be preferable to restricting investments to those authorised by Order or the Commissioner’s list.
The traditional definition of what constitutes a “blue chip” investment such as that of AIB shares in the opening example has clearly been shown to be wanting by recent market events and consequently both legislators and trustees have had to redefine their approach. For reference, the approximate decline in value of shares in Allied Irish Banks over the twelve months to26th April 2009 was 94.22%. [i]
For many years UK trustees have had to take care in investment matters “as an ordinary prudent man would take if he were minded to make an investment for the benefit of other people for whom he felt morally bound to provide”,[ii]                                                                     
Yet it is becoming clear that in our increasingly litigious society, the beneficiaries of trusts are now more willing to make claims against trustees because of poor investment performance, even where the investment management has been delegated to an investment professional. To borrow from the lexicon of shipping; if a loss happens on "your watch" you have to answer the questions.
In investment circles the often cited case of Nestle v National Westminster Bank plc, 1992 is considered somewhat of a turning point in the willingness of the courts to hear cases of professional mismanagement - with reference to "incompetence" on the part of the trustees.
The crux of this question therefore boils down to this; which is more important, investment strategy or the selection of an investment advisor?
Trustees may naturally tend to assume that the selection of an investment adviser is the most important part of this process. Since, especially if they lack investment experience themselves, by taking proper advice and appointing an “expert” and professional fund manager, they might hope to free themselves from some of the responsibility of the investment management of the trust assets.
In section five of the Trustee Investment Act 2000 “proper advice” is defined as meaning “the advice of a person who is reasonably believed by the trustee to be qualified to give it by his ability in and practical experience of financial and other matters relating to the proposed investment”.
However, there is an often overlooked but non-the-less important dimension to this process which is that; in obtaining and considering this “proper advice”, Trustees should also ask the question “how is the adviser remunerated?” Many advisers are paid, either directly or indirectly, some form of commission and this form of remuneration immediately calls into question the impartial and independent nature of their financial advice.
Indeed in the UK whilst on the one hand legislators are urging trustees to seek professional advice at the same time reports, commissioned by the UK Government, have questioned the impartiality of this advice:
“Consumers rely heavily on advice from intermediaries, although they have almost no understanding of the costs of obtaining this, and are unable to gauge its quality. Moreover, the advice itself is often compromised by the incentive effects of commission paid by product providers.” [iii]
The fact is that the financial advisory industry often focuses on selling products and earning commissions, with the financial well being of its’ clients of secondary concern. The result is a regular stream of mis-selling scandals, most of which must be caused by the need to generate commissions.
Sadly, regulators are all too aware of these situations and Sir Callum McCarthy, Chairman of the UK Financial Services Authority, stated at the Gleneagles Savings & Pensions Industry Leaders’ summit in September 2006 that:
“Consumers are not always advised on transactions which fail to remunerate the adviser, or which offer little by way of commission to the adviser.” and “The present distribution system is distinguished by a focus on business volume rather than quality.”
Commissions are an inducement to sell products and the bigger the commission the bigger the inducement. The current system of fund management and advisory services is characterised by a desire, indeed a compulsion, to sell products often with opaque and relatively expensive charging structures.
This is not to say that all advice provided by the established financial firms will necessarily always  be poor but that the evidence suggests that the inherent conflicts of interest created by commission payments is often too high a bar to the provision of truly impartial advice.
Trustees should therefore look to alternative sources of guidance to establish their framework of “ordinary prudence”. For example, borrowing from the USA[iv]
Five Principles of Prudence
1. Sound diversification is fundamental to risk management and is therefore ordinarily required of trustees.
2. Risk and return are so directly related that trustees have a duty to analyse and make conscious decisions concerning the levels of risk appropriate to the purposes, distribution requirements, and other circumstances of the trusts they administer.
3. Trustees have a duty to avoid fees, transaction costs and other expenses that are not justified by the needs and realistic objectives of the trust’s investment program.
4. The fiduciary duty of impartiality requires a balancing of the elements of return between production of current income and the protection of purchasing power.
5. Trustees may have a duty as well as the authority to delegate as prudent investors would.
The reporter’s notes on the Prudent Investor Rule point out that; ”Empirical research supporting the theory of efficient markets reveals that in such markets skilled professionals have rarely been able to identify under priced securities, (that is, to outguess the market with respect to future return) with any regularity. “

This means that in considering the selection of an investment strategy, trustees also need to consider the ongoing debate around “active” Vs “passive” investment management. This holds that there are two broad forms of investment management styles:
·         Active – a fund manager attempts to add value by picking securities, or attempting to time entry or exit from markets typically high turnover strategies which can result in high costs.
·         Passive – a low cost and passive form of investment where an investment is simply designed to follow an index fund which seeks to replicate the performance of some broad benchmark such as the ISEQ or S&P 500.
Active managers stress that despite their, on average, higher fees they can still add value. However, this debate can be addressed though a simple arithmetic argument.  If "active" and "passive" management styles are defined in sensible ways, it must be the case that:

“before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar. These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required” [v]
Despite this intuitively logical position, the traditional view of investment matters, and that perpetuated by much of the Financial Establishment, is that investment managers should strive to attempt to beat the markets by taking advantage of pricing "mistakes" and attempting to predict the future.
An examination of the academic literature suggests that the overwhelming evidence points to the fact  that selecting investment advisors on the basis of their "skill" as active investment managers does not result in positive expected outcomes for Trustees and in fact exposes them to unnecessary idiosyncratic risks.
By this we mean that in order to decide which fund manager is the “best” the Trustee needs to make a subjective value judgement. They need to select a manager based on some preference, and typically this is based on some form of expectation that the “expert” will deliver strong returns in the future since they have delivered strong returns in the past.
Research in the United States examining the selection and termination of investment managers by 3,600 plan sponsors over a 10-year period from 1994 to 2003, found that plan sponsors hire investment managers after these managers earn significant excess returns. Post-hiring returns, however, are statistically indistinguishable from zero.
In contrast, plan sponsors terminate investment managers after poor performance but the performance of these investment managers appears to rebound after firing.  The conclusion reached being that the termination and selection of investment managers is a costly endeavour but adds little to investment returns. [vi]
The first study into actively managed mutual funds “The Performance of Mutual Funds in the Period 1945-1964” was published by Michael Jensen in The Journal of Finance in 1965. It documented the failure of investment professionals to outperform the appropriate market indexes. Similar studies have repeatedly confirmed the original Jensen findings for example:

Source: Mark Carhart, “On Persistence in Mutual Fund Performance,” Journal of Finance, 52, No 1 (March 1997) 57-82
Where a Trustee seeks to engage in any decision making process which requires the assessment of the “skill” of an active fund manager, it is our belief that this process sets up a dynamic which inevitably leads to failure.

"The idea that any single individual without extra information or extra market power can beat the market is extraordinarily unlikely. Yet the market is full of people who think they can do it and full of other people who believe them….Why do people believe they can do the impossible? And why do other people believe them? [vii]
The conclusion we reach is that the futility of speculation is good news for the informed investor. It means that prices for public securities must generally be fair and that persistent differences in average portfolio returns are therefore largely explained by differences in average risk rather than being attributed to the skill or otherwise of a fund manager. It is certainly possible to outperform markets, but not in general without accepting increased risk.
Therefore, in the selection of an investment strategy, rather than paying an active manager to analyse individual securities or time the markets, investing becomes a relatively simple matter of deciding how much relative risk a Trustee should take for example; how much stock to hold versus how much in bonds.  In other words, the asset allocation decisions relative to the needs of the trust.
This conclusion is supported by the most famous and comprehensive study into the significance of Asset Allocation[viii] in 1991 with similar conclusions being drawn from most studies. The bottom line is that considering everything, over 90% of long-term portfolio performance is derived from the decisions made regarding asset allocation.
We would argue therefore that the Trustees’ principal objective in the selection of an investment strategy should be to seek to understand and to manage their exposure to investment risk through the asset allocation decisions that are made relative to the investment term of the trust and the needs of the beneficiaries (income or capital distributions etc). They should ensure that their risk exposure is consistent with the objectives of the trust to the highest degree of probability despite the high levels of uncertainty associated with investment matters in general.
Evidence from practising investors and academics alike points to an undeniable conclusion: expected investment returns are related to exposure to investment risk. Gain is rarely accomplished without taking a chance, but not all risk-taking is rewarded.
When considering an appropriate asset allocation strategy, Trustees should also take account of such issues as:
(a) the nature of the liabilities of the trust,
(b) an appropriate diversification of investments, including appropriate diversification of credit and counterparty risks, and
(c) the appropriate liquidity of investments especially where capital is to be advanced to beneficiaries.
Successful investing of Trust capital means not only capturing risks that generate expected return but reducing risks that do not. Avoidable risks include holding too few securities, betting on individual countries or specific industries, following market predictions, and speculating on "information". To all of these simple diversification is the antidote. It washes away the random fortunes of individual stocks and positions a portfolio to capture the returns of broad economic forces.
For example, for many Irish Trustees, the ISEQ Index might represent a meaningful equity asset class in a diversified portfolio. Yet at the end of September 2008 the entire Irish Stock market represented just 0.22% of the world according to the Morgan Stanley World Capital Index. [ix]
Investing heavily in Irish companies as many Irish Pension fund managers have historically done[x] exposes a Trustee to risks but these risks can be diversified away simply by holding a wider range of securities for example:
 

MSCI data copyright 2009 used with permission
This is the power of diversification: the whole is greater than the sum of its parts. In this case an investment in the wider European Market has resulted in a better outcome than an investment in a relatively narrow range of Irish Companies. In this way, investors focus on the factors that drive investment returns, reducing excess and undesirable risks.
In summary in appointing a Professional investment adviser, the trustees should act prudently in the following:
·         Selecting the agent ensuring that:
·         their remuneration is in the form of a fee rather than a commission;
·         that their agent is familiar with the principles of modern portfolio theory and diversification between asset classes e.g. Property, Equity, Bonds and Cash;
·         that their advice relates to an appropriate asset allocation for the trust rather than security or investment fund specific advice;
·         that costs are kept as low as possible through the use of mainly passive index funds;
·         the terms and limits of the authority delegated are established;
·         that the agent is acquainted with the investment objectives of the trust, and
·         monitoring the performance of the agent to ensure compliance with the terms of the delegation
In selecting an investment strategy trustees should be mindful of:
·         The potential needs for beneficiaries for income and/or capital;
·         The degree of risk exposure appropriate for the anticipated term of the trust;
·         The need for diversification to reduce risk.
 
ACTS REFERRED TO IRISH LEGISLATION
Age of Majority Act 1985
[Charities Bill 2007]
Conveyancing Act 1881
[Land and Conveyancing Law Reform Bill 2006]
Pensions Act 1990 1990, No. 25
Pensions Acts 1990 to 2008
Succession Act 1965
Trustee Act 1893
Trustee (Authorised Investments) Act 1958
Trustee (Authorised Investments) Order 1998
Draft Trustee Bill 2008
ACTS REFERRED TO ENGLISH LEGISLATION
Trustee Act 1925
Trustee Investment Act 1961
Trustee Act 2000
ACTS REFERRED TO AMERICAN LEGISLATION
American Law Institute’s “Restatement of the Law, Trust, Prudent Investor Rule.”

[i] Source: www.uk.finance.yahoo.com

[ii] Court of Appeal, re Whiteley 1886

[iii] Sandler Review – ‘Medium and Long-Term Retail Savings in the UK’, July 2002.
 

[iv]  “Restatement of the Law, Trust, Prudent Investor Rule” published in the USA in 1992;

[v] William F Sharpe Nobel Laureate The Financial Analysts' Journal Vol 47, No 1, Jan/Feb 1991. pp7-9

[vi] “The Selection and Termination of Investment Management Firms by Plan Sponsors” by Amit Goyal of Emory University and Sunil Wahal of Arizona State University.

[vii] Daniel H Kahnemann, 2002 Nobel Laureate in Economics.

[viii] Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower

[ix] Source MSCI

[x] Irish equities continue to be a significant component of many pension schemes with an average allocation in the region of 15%. As the ISEQ was one of the worst performing of the developed equity markets in 2007 with a return of -24.5% Source Mercer Consulting.