Fund Management

The huff and puff of ESG investing

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As a follow-up to our recent blog on ESG investing we note that the government in Canada has announced the legalisation of cannabis for all uses. Meanwhile in the UK the drug is still illegal, but specialist clinicians will be able to legally prescribe cannabis-derived medicinal products to patients with exceptional clinical need. So how does this sit within the investment debate over Ethical, Social and Governance investing?

The leading Canadian company to get onboard the marijuana puff is called Canopy Growth Corporation. It is the first Canadian cannabis grower to debut on the New York Stock Exchange with a valuation of more than US$10 billion. Putting this into perspective, Canopy is now worth more than Canadian company Bombardier, one of the largest global aerospace businesses and manufacturers of many trains in the UK. Like ‘dotcom’ and ‘bitcon’ before, is cannabis the next tulip bubble and how should charities approach this possible investment?

Ethically, there has been significant clinical evidence to support the legalisation of cannabis as a treatment of many medical and psychotic problems. Socially, despite the health benefits, marijuana is illegal in the UK and many other countries. Campaigners highlight its link to violent behaviour and serious mental health problems. As far as governance is concerned, charities may be split as to the merits of having exposure to cannabis production in their portfolios depending on whether it is for recreational or medicinal use. But surely it would be difficult for charities to advocate putting pressure on the UK government to follow the example set in Canada?

While cannabis may boost financial returns in a global portfolio, is a useful example as to why charities find ESG investing both confusing and difficult.

Getting ready for the tide to go out…

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Charity investors are offered two ways of investing: a discretionary manager who buys and sells shares directly for their client; or through an investment fund, usually called something like ‘Charity Income and Growth Fund’ and which have risk appetites varying from cautious all the way through to adventurous.  

The former (discretionary) approach requires the manager to carry out a suitability test so they understand each charity’s financial status, its need for income and its capacity to withstand capital losses. This includes looking across all the charity’s assets and liabilities. With a single investment fund it is not possible to do this. The manager cannot tailor the fund profile to the needs of each individual investor – it is a single product designed to have a specific risk profile.

A charity will commonly seek to invest in a ‘medium risk’ fund. However, the fund manager is only regulated to make sure the fund itself is ‘medium risk’ which means that the client, if they have other assets, may well have a completely different risk profile. If, for example, they hold property the overall risk the charity is taking might better be described as ‘adventurous’ rather than ‘medium risk’.

What should Trustees do? Trustees must remember that investing in a fund that is ‘low risk’ only describes that single fund. It certainly does not describe the charity’s total investment risk if it holds any other assets outside the fund. That’s why it is so important for trustees to understand the risks they are taking in the round and not simply to assume that labels on individual investment products apply to their entire charity.

Regulations don’t allow firms that offer products to consider the risks of the other assets and liabilities of the charity, only the risk of the funds they offer. That’s why independent advice is so important for any trustee body that is not confident in making these decisions about their total risk.

After ten years of very good stock market returns, we hope that all trustees will find that they are properly covered when the tide does finally go out.

Why charities need to engage

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At Yoke, we like to cycle to meetings. It keeps us fit and cuts our carbon footprint. While some say cycling in London or any city is dangerous, we manage the risks and take appropriate time between meetings, keeping within the law. The biggest risk on the road tends to be other cyclists or pedestrians, who do not appear to be aware of the rules of the road. 

We notice that it common for pedestrians at crossings wait for a bike to pass, when it is the person on foot’s right of way. This is because many cyclists think they are in charge and ignore the highway code by crossing red lights and zebra crossings, so pedestrians are naturally confused and avoidable accidents can occur.

An excellent recently published report entitled Time and Money highlights that charities who rely on investments to support their long-term mission can take advantage of their ability to make and spend more money and encourage good corporate behaviour. However, short-term thinking can get in the way.

Trustees can unwittingly be blown off-course and when investing for the long-term. It is important that Trustees should be committed and ambitious, not complacent, continually attending to the proper management of their assets but never losing sight of the main charitable goal.

Why do we link the poor pedestrian to a report about investment management for charities?  In many cases an investment manager attends the charity meeting and for usually 30 minutes, they entertain client with stories from the market. Rarely does the charity engage. Like the pedestrian at the crossing who is used to the cyclist ruling the road, charities tend not to challenge. 

Charities must engage, not be entertained, when it comes to investment. They must understand the risks and investment objectives. While the manager can advise, it is the charity that is in control and they must have the confidence to remind themselves of what they want from these assets, assess whether or not they are getting what they want, and if not, decide what action to take.   

Investment managers should also encourage their clients to be engaged by basing their presentation of how well they are fulfilling the mandate they have been given against the benchmark the charity has set. Fabulous tales of the far east and what’s going on in the Silicon Valley is simply entertainment and adds very little to the Trustees’ understanding of whether they are achieving their long term goals.

Like the pedestrian, trustees need to enforce their right and be in control of where they are going to avoid unnecessary accidents.  

Why are fund managers becoming insecure?

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The active fund management industry is going through an odd patch at the moment and showing signs of insecurity after a decade of confidence. 

Despite the economic crisis ten years ago, the fund management industry has generally ridden a prosperous wave as markets have been propelled ever upwards, with much thanks due to quantitative easing.  According to the Investment Association, the trade body for the fund management industry in the UK, assets under management have doubled to £8.1 billion by 2017. The FCA estimates that operating margins have on average been 36%, comparing favourably against the broader economy where the average operating margin for all UK listed companies, including asset management, was 16%. This is partly due to increasing AUM growing revenues much faster than costs, again improving margins.  

With the rise in profitability, the industry has seen a rise in regulation with MiFID II being introduced in January 2018 and the GDPR coming in May.

So as assets under management and profitability rise, with greater controls through regulation, why is there insecurity in the industry? 

There is a growing consensus from the fund management community that the decade long bull market in real assets may be stalling and returns in 2018 will be negligible at best. Peer group investment performance has narrowed as many fund managers appear to be making similar market calls. Market veterans have seen this before and long-term investors will digest the current hiatus with no more than a slight hiccough.

Does the insecurity exist because of what could be a crossroads of profitability and greater transparency on costs and performance? Research from Invesco PowerShares, a passive fund provider, suggested that 67% of institutional and sophisticated investors believe that MiFID II will result in increased use of exchanged traded funds (ETF) by institutional investors in Europe. The research cites transparency oflow costs and management fees being the top reason given for the expected increased flows into passive investments. 

It might feel insecure about the future and facing margin pressure, but the fund management industry must have the confidence to set out its views on the investment markets, no matter how painful it might seem. Active managers should not worry how they look compared to their peers or the passive competition, but to explain clearly the headwinds they are prepared for and the ones they will let go. They should also be more explicit about the positives of successful active management over passive or ETFs in terms of counterparty and momentum risk.

Clarity on costs and performance is good for investor confidence. Managers must demonstrate conviction on their distinctive investment approach, so clients can make a more informed choice between them. If they cannot achieve this, the managers’ profits will suffer as clients move their money elsewhere.