Trusting the numbers

Robust and effective investment monitoring within the fiduciary services industry has always been an inherent trustee duty. However, in today’s stricter regulatory and litigious environment it is even more of a necessity. Legal case law has set precedent for the standard of care expected of trustees following the investment of trust funds in terms of ensuring the performance of the investment is adequately monitored on a periodic basis.

In the 1980s, Bartlett vs Barclays Bank Trust Co (No 1) case, the obligation to monitor the performance of a trust’s underlying investment company was intensely scrutinised. It was held that trustees have a duty to either appoint a trustee representative to the board of the company or ensure they receive periodic management reporting from the board in order to fulfil their duties of monitoring performance. It was also found that the duty of care in the case of a professional corporate trustee was higher than that owed by a lay trustee and there was an overriding responsibility for the trustee to ensure the information flow in relation to the investment and the performance was adequate at all times.

Another interesting study in relation to trust investment is the 1995 Midland Bank vs Federated Pension Services case, whereby the focus of the Jersey Court of Appeal was the acts of gross negligence on the part of Federated Pension Services (as trustee) for not implementing a change in investment strategy to a pension fund. However, the fact that the performance of the pension fund had been significantly affected was a key consideration in the case.

The UK Trustee Act 2000 places specific responsibilities on trustees in relation to the investment of trust assets in terms of the suitability of the investment, the reporting, administration and tax efficiency of the investment and subsequent overview and control. Similar requirements have been adopted by the key offshore jurisdictions around the world. A trustee has to cover both qualitative and quantitative aspects and these include:

- investment objective and risk profiling;

- asset allocation;

- investment manager selection, appointment and resignation;

- investment performance and risk monitoring.

While the legal and regulatory environment is very compelling, it is not the only factor to bring about the growth of investment performance and risk measurement roles within the fiduciary industry. A professional trustee is all too aware that beneficiaries of trusts these days are so much more investment savvy. Increasingly, trustees find that beneficiaries place more sophisticated demands and have higher expectations in terms of professionalism and service in all areas of the fiduciary offering.

To retain business and attract new business a trustee must be able to demonstrate that they have the ability to be proactive in overseeing a trust’s investment portfolio. Furthermore, even if the decision making is to be delegated to a discretionary investment manager, it is still imperative the trustee has a consistent and robust framework.

The framework should encompass three requirements. First, there should be a means of profiling the trust, preferably using client profiler software, to determine the appropriate investment solution in relation to asset class and strategy. Second, a process of selecting a suitable investment manager on an open architecture basis and, finally, the use of software which enables proactive analytical portfolio performance and risk measurement reviews on a periodic basis. A trustee cannot absolve himself of his fiduciary duty by simply signing a discretionary investment management agreement.

So how does a trustee demonstrate a proactive approach to investment portfolio performance and risk measurement? Typically, there will be two options. A trustee can either choose to completely outsource the function to an investment consultant or establish an independent function within the business to deliver an investment analysis and reporting framework. The independence of the function is critical in the case of a bank owned trust business whereby some of the investment portfolios will be run by portfolio managers within the bank.

Essentially, the size of the corporate trustee’s business will determine whether a decision to resource the function internally is a commercially viable option.

The framework for the investment performance monitoring should adopt a similar approach to that of an investment management firm albeit to a lesser degree. The trustee, like the investment manager would wish to know how the portfolio has performed over the last period and, indeed, since inception. This may be from an absolute return or relative return perspective and would generally be driven by the type of manager selected and the investment mandate itself. However, it is fair to say from a general point of view, returns relative to a benchmark remain a firm favourite within the private trust industry. In addition to evaluating returns, a professional trustee should also understand how much risk a manager has taken to achieve that return. This risk measurement should also link in to the frequency of analysis as it is prudent for a trustee to demonstrate the investment performance reviews are conducted using a risk-based approach.

Consistency is another fundamental consideration to the trustee in establishing a good monitoring framework, not only in relation to their calculation of return, but also in terms of the actions they take post review and this shall be looked at in more detail below.

In light of the above trustee’s considerations, and now that the basic monitoring framework has been set out, it may be useful to look at some of the common problems associated with evaluating performance within the fiduciary services industry. These problems are perhaps more specific to the nuance of trust business and can be summarised as follows:

Underlying beneficiary needs

For certain beneficiaries, the income derived from the investment is more important than the overall cumulative performance of the portfolio. However, the trustees must balance this need with their duty to preserve and enhance the trust assets in order to discharge their obligations to other or future beneficiaries/successive life tenants and, indeed, the remainderman.

Conflicting time horizons

Typically, a private client investment portfolio will have a time horizon of three to five years or longer. Clearly, the investment performance should be assessed in conjunction with the applicable time horizon of the portfolio, however, trustees do tend to place greater focus on the most recent quarter as generally investment statements and valuations are reported on a quarterly or semi annual basis. This is why understanding the risk tolerance in terms of drawdown and recovery period should be just as important to the trustee as the return in order to manage the underlying beneficiary expectation.

Ideally, a trustee’s monitoring framework should allow for performance and risk to be measured using monthly returns, not for short term performance evaluation which may result in a ‘knee jerk’ reaction to bad performance, but to seek a more accurate analysis over the longer term and to assist in the examination of discrete and rolling periods.

Benchmark appropriateness

To measure against a benchmark or not is an extremely subjective area. As mentioned earlier, trustees and indeed underlying beneficiaries do tend to favour performance measurement relative to a benchmark. The fundamental question is how one goes about selecting an appropriate benchmark? How much reliance can the trustee place on the benchmark used by the investment manager in their reporting?

In addition to this, there is a current trend of managing investments on an absolute return basis and this has seen an increase in investment portfolio performance being reported using a ‘cash plus x per cent’ benchmark.

While there is no ‘one size fits all’ in terms of how a trustee determines benchmark appropriateness, a good place to start is to evaluate whether there is a need for a target return benchmark and if there is a need, to ensure the index or composite to be used as the benchmark is discussed and agreed between the trustee and the investment manager at the outset of the relationship.

Consistency of assessment and subsequent actions

A private client trustee will be expected to monitor investment portfolios run by a number of investment management firms, and of various values and compositions. Moreover, in order for the assessment to be deemed credible and stand up to external scrutiny it should be conducted in a consistent manner so that a systematic approach to performance evaluation can be demonstrated across all portfolios.

This paradox is understandably a key difficulty for trustees in delivering this aspect of their monitoring framework. Data collection and handling, methodology of calculating return and treatment of fees and charges all have potential to seriously impact a trustee’s assessment of the manager. Arguably this is the area that will most greatly influence a trustee in deciding to outsource the performance function to an investment consultant. For those trustees who have the appetite to tackle this difficulty, the two key considerations for establishing a consistent and systematic approach to performance evaluation would be to select an appropriate method for calculating return and apply it to all portfolios and to ensure the communication to the investment manager when requesting data is clear and definitive.

If a trustee is successful in achieving a systematic process for evaluating investment manager performance a clear audit trail can be evidenced at any time. Furthermore — and most fundamentally — any action that may follow in terms of a decision to change a manager and/or deal with poor performance will always be fully supported by statistics and methodology.

This, in turn, allows the trustee to adequately respond to their underlying beneficiary expectation to the professionalism and standard of service and from a statutory perspective, to remain confident they are continually safeguarding a trust’s assets, thus fulfilling their fiduciary duty.