Step 2: Setting investment strategy

Importance

This is the single biggest investment decision that a group of trustees will make.  It may be the single biggest decision, period.  For small schemes where there will typically be limited resources in terms of time and money to spend on investment work, it is vital that this area is given the focus it needs. 

Despite this, frequently we see trustees spend too high a proportion of their time discussing and analysing their choice of fund managers.  This is understandable as it‘s easily measurable and interesting, but we think this is misguided.  There’s no point even looking at fund managers unless you have a sensible investment strategy in the first place.

Strategic versus tactical investment decisions

Most investment decisions are either tactical or strategic.  Strategic issues tend to be long-term, but more importantly they are based on an understanding of the objectives, liabilities and needs of the scheme.  They may be coloured by some long-term observations such as over the long term we expect equities to outperform bonds.

Tactical issues are based on predicting which markets (and which securities within those markets) will do well, and which ones will do badly.  Tactical decisions tend to be shorter term.

The bad news for trustees is that the strategic decisions are their responsibility and they are the more important of the two.

The good news is that they are easier to make than the tactical decisions.

Investment consultants, such as us, are experts who can advise the trustees on strategic issues.

We strongly recommend that trustees avoid making tactical decisions themselves.  If you want tactical view to be taken into account, we recommend that this be delegated to fund managers.  This is their area of expertise (and it is far more difficult than it looks).

There is no point asking an investment consultant for help with tactical, market-based decisions or a fund manager about strategic issues.  Although they appear to be related fields, they are completely different and complementary skills.   If you were building a house you would probably want an architect as well as a builder.

If you want a fuller explanation of our views on tactics versus strategy see our blog post of 4 May 2011.

There are two aspects of the strategy to consider, the strategic asset allocation and the investment structure.

Strategic asset allocation

What do we mean by a strategic asset allocation?  Here’s an example (it’s for illustration only; we are not endorsing anything about this particular strategy).

The main issues to address are:

• The split between ‘equities’ and ‘bonds’

More correctly, this is called the split between ‘growth’ and ‘hedging’ assets.  Growth assets include equities (UK, overseas and emerging markets) and most alternative assets (including high yield bonds).  Hedging assets includes bonds, cash and pooled LDI funds.  So in the example above the ratio is 55% growth assets; 45% hedging assets.  Generally the more risk averse you are as a group of trustees, the lower your allocation to growth assets should be.

• What type of ‘equities’ should you invest in?

Follow this link for our views on growth assets.

• What type of ‘bonds’ should you invest in?

Follow this link for our views on hedging assets.

• Should alternative investments be used?

We have articles on property, private equity and hedge funds.

A major part of answering these questions is to consider what it is that you’re trying to achieve.  That is why we believe that Step 1, setting your investment objectives, is absolutely vital .

Although we cannot predict the future, investment consultants can help you put together a strategy that gives you the best chance of meeting your goals.  In a game of cards you can’t predict what the next card will be, but you can adopt a strategy that gives you the best chance of winning given the hand that you’ve got and an understanding of probability.  (Fund managers will try to predict the next card.)

The main tool that investment consultants use to help trustees make this fundamental decision is an Asset Liability Model (ALM).  There is a wide variety of ALMs available, but the general aim is to see how potential strategies might affect your scheme’s funding position in the future.  Follow this link for a detailed explanation of ALMs.

Investment structure

The issues to consider here include:

• The number of fund managers
• Active v passive
• With-profits
• Diversified Growth Funds
• Multi-Managers