Jump in the pool?

When implementing an investment strategy, what are the pros and cons? of taking a pooled or a segregated approach? Richard Maitland explains which of the different strategies will be most appropriate for your school

While there should be a clear distinction between a “pooled” (using funds to implement investment policy) and a “segregated” (owning positions in individual stocks, shares and bonds) investment, in the charity sector the water has been muddied. Specifically, many charity investment managers offer what they call a segregated service when what they really mean is a “semi-segregated” service. This typically involves investing directly in Government bonds and UK equities and in a selection of unit and investment trusts, where allocations are made to overseas equities, corporate bonds, property and other peripheral asset classes such as hedge funds and private equity.

The bulk of charity portfolios used to be invested predominantly in a segregated manner. However, given the reduction in exposure to UK equities (WM reports 62 per cent in 1999, compared to just 42 per cent now) and the increase in exposure to overseas equities, corporate bonds and other newer asset classes, there has been a significant increase in the proportion that is invested in funds. This raises questions about increased costs, levels of transparency and ethical compliance.

So, which?
In the pure institutional world, few pension fund trustees would consider a segregated approach unless they had well over £25 million to invest. This is a significantly higher figure than many trustees would consider (or have at their disposal) which many charity investment managers recommend.

Attitudes to pooling vary. Equally importantly, given the resources at hand (people, money and legacy IT systems), 15 years after charity investment became a clearly defined specialisation, you can still see the genetic imprint in many current offerings. So, while much of what is sold to trustees takes advantages of changes in markets, technology and investment understanding, some attitudes and advice appear to be anchored in the past, which suggests an inability to evolve.

Take a step back
It is worth considering what needs to be done before choosing the most appropriate method of implementation: in some cases, your decisions might be made for you. The most important thing is to ensure that the charity has a clear strategic investment policy. This will form part of an overall reserves policy. Specifically, you must ensure that short- and medium-term monies (working capital and monies that need to be put to one side ahead of any known spending requirements) are clearly defined and not confused with genuinely long-term monies.

The next stage is to agree some broad secondary strategic issues in early-stage consultation with your current investment manager or consultant, among the trustees, or indeed following some preliminary meetings with prospective investment advisers/managers.

The questions to ask:
• do we wish to implement policy in a passive (index-tracking) manner or do we wish to appoint active investment managers? If you choose a passive approach, you are in effect agreeing to a pooled route at the outset. However, you will then need to decide on a different set of questions in terms of whether you wish to buy unit trust trackers, exchange traded funds (ETFs) or futures;
• are you happy to work with an individual investment manager operating off a core house model, or do you wish to buy into flagships funds? Some trustees prefer a personal approach (the stockbroker model), while others will want to achieve results in line with an investment company’s key public funds. The latter requirement will lead you towards a more pooled/funded route; and
• do you want to pursue an investment strategy that involves above-average levels of turnover or use of derivatives (many target/absolute return-type strategies)? In most instances, it will be easier to go down the pooled rather than segregated route if this is your objective.

If you are considering a conventionally managed, active, multi-asset class portfolio, then you should consider whether a fully segregated, semi-segregated or fully funded route would be best for you.

While it is possible to manage relatively small sums of UK equities and UK Government bonds in a segregated manner in a risk-appropriate and efficient manner (£1m+ allocations), you would need at least that amount to invest in a prudently diversified fashion in overseas equities, corporate bonds, property or alternative asset classes. Few UK charities are able to invest in a genuinely segregated manner across their entire portfolio: so, the debate quickly becomes semi-segregated v pooled.

Trustees should consider the following:
• can your overall (bespoke) asset allocation be achieved by mixing individual holdings with a number of single (or indeed multi-) asset class funds?
• to what extent will the transparency of the underlying holdings be masked by holding funds rather than individual securities? To what degree does this matter to the trustees?
• will there be an unacceptable build-up of costs (potential double-charging issues) if a large part of the portfolio is managed in pooled funds not run by your appointed manager?
• if you have an ethical investment policy, does it matter that it is probably not being applied within some/all of the funds your strategy is now partially/mostly being implemented through?
• what level of administrative burden can you cope with? Segregated investment management can be more flexible, but almost always results in a much heavier flow of paper, stiffer book-keeping requirements and more complex year-end audit than a pooled/funded approach;
• with segregated accounts, remarkably small deviations between holdings can result in significant differences in performance. This can be fine, but you need to track the performance of your manager relative to the house’s published record and mean returns; and
• when policy is implemented through a single multi-asset class fund, or indeed a limited number of single asset class funds, is the reporting of a standard and transparency that allows the trustees to review their investments and performance properly? Standards vary significantly and can be poor, particularly with some pooled services: this will be a major factor in driving your ultimate decision.

If you are going to use funds as part of a pooled or semi-segregated approach, should you favour common investment funds (CIFs) over unit trusts, open-ended investment companies (OEICSs), investment trusts or indeed ETFs? After all, they have been designed especially for charities and, for the time being, are regulated by the Charity Commission.

While, in some instances, there are tax breaks (no stamp duty on UK equity and property transactions), there are tax penalties: VAT on investment management fees, which are not charged within non-CIF pooled funds. The tax benefits are marginal, while other fees and relative performance are more important. Many trustees feel that CIFs with advisory boards and independent trustees have an added level of security and external scrutiny that proprietary units trusts and OEICSs don’t have.

How deep?
The ultimate decision will not be segregated or pooled for most charities, but rather “how pooled” can you go while still ensuring that you can construct an investment portfolio in keeping with your chosen strategy.

Your chosen method of implementation is flexible enough to grow and change as you do, and that any specific ethical requirements are applied to all of/an acceptable proportion of the portfolio. Lastly, you should convince yourself that your fund manager is capable of changing the chosen method of implementation, should your circumstances change or investment markets evolve. If all that is possible, and the transparency and levels of reporting are good enough, then pooling can make a great deal of sense.

Richard Maitland is head of charities at Sarasin & Partners LLP. Richard can be contacted on richard.maitland@sarasin.co.uk or 020 7038 7000.

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