Face off

The interaction between trust practitioners and investment managers has altered considerably over the years for those trust companies truly looking to add real value to their clients. In these challenging times, trustees are more conscious than ever of their responsibility to remain engaged – getting more involved in the investment process, and ensuring that they truly understand the current management of their clients’ assets.

Risk taking

Private investors, accountable to no one but themselves for the consequences of their investment decisions, accept that, particularly in times of high volatility and uncertainty, they are going to have to place their capital at risk in pursuit of growth and profit opportunities. Trustees, with a duty of care towards their beneficiaries that may span multiple generations, have to balance the objective of wealth enhancement with the overriding objective of wealth preservation.

In bull markets, the balance may be easy to strike, particularly when there appears to be a high correlation between asset classes and all managers seem to be making money. Shortcomings in the investment process can be masked in good times but, when markets become volatile, the cracks will rapidly manifest themselves and trustees may be criticised for underperformance and the destruction of trust capital.

Trustees must have the beneficiaries’ complete needs, and their own duties, at the forefront of every decision they make in the investment management life cycle.

Prudent trustees go to great lengths to ensure that they have a complete understanding of the ongoing needs of the beneficiaries to whom they owe their duty of care. If the trustee does not understand the current and future needs of the beneficiaries then it is impossible for him to translate those needs to the investment manager. Disappointment and discord will be the inevitable consequence if all stakeholders in the process do not have a shared vision of what the end result is supposed to be.

Settlors and beneficiaries now expect more from their trustees and, while they may recognise that the trustee is not qualified to provide investment advice, a good understanding of the investment process is needed. Trustees need to be able to converse intelligently on all manner of topics such as the long-term purpose of the trust, the needs of the beneficiaries and the settlor’s intent, risk profile, asset allocation, currency exposure and restrictions on an ethical ?or tax planning basis.

Assets entrusted to trustees are normally only a proportion of a settlor’s overall wealth – for some it might be a small amount, while for others it may be their life savings. Trustees must understand what is motivating the settlor so that a clear picture can be built for the investment manager to make suitable recommendations as to how the portfolio may be structured. This will include limits or restrictions on certain asset classes to avoid having unhealthy levels of exposure on a global basis and/or taking into account particular tax issues that have a material influence on investment selection. The importance of complete discovery by trustees at an early stage in their relationship with the settlor cannot be overstated.

Beauty parade

Selecting an investment manager is not straightforward if the trustees wish to fully discharge their legal and commercial obligations. Trustees are exercising a power to delegate and must do so with care and diligence. Investment managers cannot be experts in every field and all will admit to a favoured investment approach, asset class or currency.

It is imperative that a professional trustee understands the speciality that each investment house brings and the personalities within it. Over time, the values and approach will be the deciding factor rather than the success of one individual. Trustees favour relationships with investment managers with a proven track record, a transparent rationale, ?a clear understanding of what is happening right now and an ability ?to demonstrate independence.

Armed with their preferred list of investment managers based on due diligence, discovery, risk return profiles, investment time horizons and historical performance, modern trustees can make informed recommendations and arrange beauty parades to assist in the decision-making process. Trustees should actively participate in such meetings, to be able to challenge the investment manager if required. Trustees now should work hard to drill down and really understand the implications and limitations of the investment proposals tabled by investment managers. They must understand the projected yields, the asset and currency split, the risk ratings and the reasons why a portfolio is structured as it is.

After all, trusts exist for a long time and must look after future as well as current generations. This does make trustees generally more risk averse at the start of the investment management life cycle, even with a time horizon that is much longer than a private individual’s perspective. Obviously, the initial parameters and risk appetite will be influenced by the wider circumstances of the family and will undoubtedly need to change over time to reflect the changing needs of the beneficiaries. Being able to react promptly and appropriately to this is an essential competence for trustees and investment managers alike. The critical point at the start of a relationship with an investment manager is to ensure they are fully engaged and challenged on past performance and approach to decision making – particularly in a time of stressed markets.

Historically, settlors and beneficiaries accepted the ‘one-stop shop’ offered by trust companies owned by banks or investment houses. Increasingly, however, they are coming to appreciate the benefits of an independent approach. When the trustee and the investment manager operate independently the risk of conflicts of interest is much reduced. An independent trustee is at liberty to hire or fire based purely on the manager’s performance and suitability without the distraction of internal politics and pressure from head office.

However, there is an issue when independent trust companies rely on retrocessions from investment managers for business that they introduce or look to make a turn on pooled client funds or exchange rate margins. While we have always taken the position that any such ‘commission’ should be paid back to the client entity, this is certainly not a standard or unanimous practice. Retrocessions are apparently attracting regulatory attention and it would certainly be a contentious issue if the level of retrocession was allowed to influence decisions over manager selection and retention.

Surveillance system

While trustees can delegate the management of the trust’s investments, they cannot abdicate responsibility for their ongoing performance. Constant monitoring is required by the trustees to ensure that the investment manager continues to act in accordance with the mandate and that he compares favourably to a range of metrics such as an agreed benchmark, appropriate peer group or the absolute return, to name but a few.

This trustee obligation and the increased expectations of the regulators in this area have spawned a new advisory service where specialist firms undertake the investment monitoring process and report to the trustees. While this may have some advantages, certainly with economies of scale and the ease of data transfer, there is a concern this could lead to a disconnect between those reviewing performance and those who are responsible for understanding the needs of the beneficiaries.

An alternative is to undertake the investment monitoring function in-house. This engenders a strong sense of responsibility on all those involved to understand the investment manager’s performance and ensure it is aligned with the trust’s and the beneficiaries’ overall needs. Under-performance, or indeed over-performance, is flagged early and the investment manager can be called to account.

It also helps if administrative staff are trained to a high degree to understand the investments. At Nerine, they are required to take part in regular internal meetings to assess investment performance and must be in a position to explain any deviation from the expected returns so that decisions concerning the future investment management can be discussed. The benefits of this collaborative process have been wide-ranging and have certainly raised awareness and understanding of investment issues across the board. Even where external investment monitoring is involved, as is often essential for higher-value trusts, this increased competence and confidence adds tremendous value ?to the process.

A trustee must be actively involved in ongoing management and interaction and this is the key – they must manage and monitor the investment relationship and not just wait to receive reports, or, worse still, receive reports and do nothing with them. The game has changed way beyond returns alone and accountability now needs to be demonstrated more than ever before. Of course, trustees and investment managers could be penalised if they do not fully discharge their duties but the true motivation of a responsible trustee is the desire to go beyond the legislation in terms of responsibility and even sometimes beyond what a settlor may want if it is in the best, long-term interests of the beneficiaries.

Tips for a fruitful relationship

Do

• Make sure everyone understands what is really needed and expected from the investment management
• Select the investment manager that is best suited for the investment style
• Make sure you understand the jargon
• Understand the true cost of the service – total expense ratios matter
•  Monitor the investment performance and challenge the investment managers
•  Constantly revisit whether the investment management is suitable for the changing needs of the beneficiaries
•  Change investment managers if it is appropriate to do so

Don’t

•  Panic – investment managers will not always hit targets – think long term
•  Think that over-performance is necessarily a good thing
•  Appoint investment managers for any other reason than competence and suitability
• Be reactive – maintain a regular dialogue with the beneficiaries about their needs
• Relax or ease off when everything is going well – invariably something will not be
• Be blinded by the science – do the explanations concerning performance and process make sense?
• Confuse meeting benchmarks with performance – if index tracking is all that is needed, buy a cheaper exchange-traded fund

Kevin Masterton is a director at Nerine Group of Fiduciaries