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No hard & fast rules
There are no hard and fast rules about what the right investment benchmark for a charity is. It is important that whatever benchmark is set it should have a reference to the time horizon of the investment, the Trustees’ attitude to risk and any restrictions on investment. The benchmark should directly relate to the charity investment objective and be clearly understood by all. Benchmarks fall into the following categories:
Peer Group Benchmarks
This is a measure of the average asset allocation of a particular group of charity funds that typically subscribe to an investment monitoring service, e.g. Wealth Management Association (WMA). The weakness with this benchmark is that it uses historic information and is no guide for what may happen in the future. A manager can perform well against the index but still lose capital if markets are falling. While it is a useful guide to how other charities are investing and a good reference to how your investment manager is performing against the average, the average asset allocation may not be appropriate for every charity, given their investment objectives. It may also not reflect the objective that Trustees have set their manager so it could be like comparing apples with oranges.
A benchmark to measure an active share selecting manager, that has an aim to outperform a particular index. Depending on the mix of assets in a charity’s investment fund, it is typical to construct a composite of indices which reflects the overall investment strategy. The manager’s objective is then to beat this composite benchmark after costs. While this is also a good measure to compare one investment manager over another, it might not reflect the financial need of the charity. In reality, many investment managers will adhere closely to the investments in the benchmark they have been set to avoid the risk of underperforming it. Therefore, Trustees are left with the manager’s skill at picking stocks which most fail to do after expenses are deducted. Worse still, if the Trustees have set benchmarks which go on to produce negative returns over a long period (as has been the case with most major equity indices since 2000), the charity will not earn the returns it needs to fulfil its objectives and obligations.
Absolute or Total Return Benchmarks
Measures that are set with reference to a particular objective, typically cash or inflation. This type of benchmark is arguably the most appropriate for charities and foundation which have staff to pay and/or which wish to make regular grants to beneficiaries. Usually the objective is set to provide a ‘real’ rate of return over and above inflation (RPI plus) although it is sometimes set against cash returns, which can be regarded as risk-free returns. Many Trustees take the view that if the charity investment manager is not tasked with at least beating the return of cash over time there is little point in investing at all.
These benchmarks also allow the manager much more flexibility with asset allocation as they are not constrained to a particular index or peer group and they can reduce risk and preserve capital in falling markets. The objection to these benchmarks is that it is difficult for a Trustee to quantify whether the target is challenging enough and perceived to be easy for an investment manager to beat. Additionally, Trustees may perceive that they do not necessarily suit a charity that is seeking a high income return, although total return benchmarks can be set to ensure that a proportion of the total return target set is generated in the form of incom.
We believe that this type of benchmark should be considered by all Trustees, together with the adoption of a total return investment policy. Charities in general are aiming to pay future grants, operational overheads and other costs. Therefore their objective is to grow capital and income at least in line with inflation. By using this benchmark, the investment policy is much more in line with the real objectives of the charity and there is a better trade off between risk and returns. Trustees can always compare themselves or their manager to the peer group for reference providing it is understood that the results could be very different over the short term.