A Discussion Paper

Towards More Effective Investment Management

Prepared by the

General Synod Financial Advisory Group

August 2003

Page

1. Introduction 2

2. Major asset classes, their returns and associated risk 3

3. The principles of asset allocation 7- Objectives and time horizons- Risk tolerance- Current and future needs- Investment constraints- Consolidation of investment funds- Decision making and oversight

4. Constructing an investment portfolio 10

5. Evaluating and reviewing investment managers 12

6. Fees and charges 14

7. Possible investment portfolios 15

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1. Introduction

The Terms of Reference of the General Synod Financial Advisory Group (the Advisory Group) include:

“ (vii) To provide recommendations to the Dioceses which will assist them in the management of their finances and assets, including when necessary on appropriate organisational and decision-making structures;”

The Advisory Group has received several approaches from Dioceses over the past couple of years concerning the adequacy of investment returns. While the assets and investments of Dioceses vary greatly, the effective management of those assets and investments will be important to all Dioceses. And the general principles upon which their effective management should be based are likely to apply regardless of size.

At a time when many Dioceses are being challenged by declining congregations and income, this can make a critical difference to the ability of a Diocese to provide adequate resources to achieve the goals it sets for its Christian mission.

An earlier discussion paper issued by the Advisory Group emphasized the need to prepare accurate and comprehensive financial accounts to facilitate the effective use of limited Diocesan resources (Financial Reporting by Dioceses & The Application of Australian Accounting Standards, August 2001); early this year a framework for the preparation of a ‘benchmark’ set of accounts was recommended to Dioceses. A further discussion paper (Diocesan Key Performance Indicators, November 2002) outlines ways in which information can be organized to enhance the ongoing management of Diocesan finances.

This discussion paper sets out the general issues and principles involved in effective investment management, and recommends how Dioceses can move towards this goal.

However, the Advisory Group is not a financial advisor and recommends that Dioceses seek professional financial advice in this regard. The Advisory Group is able to discuss the principles of asset allocation and investment oversight outlined in the discussion paper, and is willing to use its best endeavours to facilitate approaches to advisors or fund managers by individual Dioceses.

As with previous discussion papers, the Advisory Group welcomes comments from Dioceses on this paper and the issues raised within it. Comments should be sent to:

The Chairman, General Synod Financial Advisory Group, PO Box Q190, QVB Post Office, Sydney, NSW 1230

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2. Major asset classes, their returns and associated risk

The major asset classes considered by investors and their financial characteristics are:

CashCash not only includes current bank balances but also securities that generally provide a (relatively) stable capital value and current interest income. They are typically short-term investments, with a low risk of loss of invested capital.

Fixed InterestCorporations, governments and semi-government authorities issue fixed interest securities generally referred to as bonds. They typically offer higher returns (or yields) than cash, but when other interest rates rise, bond prices (or the capital value of a bond) will generally fall in order to maintain comparable yields in the market, and vice versa.

PropertyIn addition to direct property investment such as office buildings, the property asset class includes securities or units issued by companies, property trusts or property syndicates. They in turn invest directly in physical properties. Some of these securities are listed on the stockmarket and are called listed property trusts. Unlike physical property, which can be difficult to sell quickly, listed property securities can be readily traded on the stockmarket.

Shares (or equities)Shares give an investor part ownership in a company (capital) as a well as a right to receive dividends (income). Shares tend to be riskier, or more volatile, than other types of investments. However, over time, shares have also provided higher returns than fixed interest securities and cash. Within this asset class both Australian and international shares are usually included when building a diversified portfolio.

Asset Classes Investment Timeframe

Perceived RiskProfile

Type of Return Examples

Cash Short term - usually up to 1 year

Low Income; No Growth in Capital

Cash management trusts, bank deposits and short term bank bills

Fixed Interest Short to medium term - usually 3 to 5 years

Low to Medium Income; Some Growth in Capital

Treasury notes, debentures, fixed interest trusts and mortgage trusts

Property Long term - usually 5 years or more

Medium to High Income and Growth in Capital

Commercial, office, industrial, hotel and retail listed property trusts

Shares Long term - usually 5 years or more

High Growth in Capital; Some Income

Shares listed on the Australian and international stock

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exchanges

In the context of more effective investment management, the key focus of attention should be on the expected returns and the associated risks for each asset class.

Relative returns

Table 1 compares annual investment returns of each major asset class since 1984, and with several types of diversified portfolios. Historically, shares and diversified portfolios have provided higher long-term returns than exclusively income-generating assets such as bonds and cash. When compounding is taken into account (as a result of reinvesting at least some of each year’s earnings), these differences can create even more substantial variations in total returns over time.

Table 1

The period from 1984 to 1999 was particularly favourable for all asset classes, largely because economies generally expanded and inflation and interest rates declined (both in Australia and in most other countries). However, past returns may not be indicative of future returns, although the pattern of returns is likely to continue in the future with growth assets such as shares expected to have higher long-term returns, despite being more volatile, than cash.

Risk

Because most investors wish to enhance the total return from their assets but limit the risks from investing, and since no individual investor (or investment manager) can accurately predict how each asset class will perform in the future, diversification of an

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investment portfolio across all asset classes is usually recommended. The nature of this decision, and subsequent changes to it, will largely determine the long-term returns and volatility of any investment portfolio.

It is therefore important that any investor understands the broad nature of investment risks and the trade-off between the risk and returns from different assets, even if it is only to recognize the likely consequences of a ‘passive’ decision not to diversify.

In order to pursue higher returns, an investor must be willing to assume additional risk. While shares and property securities tend to provide higher long-term returns than cash, for example, they can also expose an investor to higher levels of risk, particularly in the short run.

But time has a moderating influence on market risk – that is, the longer an investment is held, the more likely that it will earn a positive return. Chart 1 compares the risk associated with the major asset classes by displaying their range of returns for 1, 5 and 10 year periods over the last eighteen years. As can be seen, the range, or volatility , of returns reduces over time for all asset classes, but particularly for growth-oriented assets such as Australian and international shares.

Chart 1

Holding diversified investments across each of the asset classes can therefore moderate the overall market risk of a portfolio. Unfortunately, no matter how well diversified an investment portfolio, it is impossible to eliminate all risks. Some important investment risks are:

Inflation Risk - rising prices due to inflation can erode the real value, or purchasing power, of invested funds. If an investment earns 6%, but inflation is

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Volatility of Major Asset Sectors - Range of ReturnsOver 1,5 and 10 Year Periods (1 January 1985 - 30 September 2002)

-40

-20

0

20

40

60

80

100

Cash

Listed PropertySecurities

1 5 10 1 5 10

Australian Fixed Interest

Australian Shares

1 5 10 1 5 10

International Shares

1 5 10

% p.a.

International Fixed Interest

1 5 10

Source: Vanguard Investments

4%, the real return is only 2%. This risk is particularly relevant for cash investments where the possibility of low, or even negative, real returns can be quite high. Over long periods in the past, the higher returns from shares have outstripped inflation by larger margins than either fixed interest securities or cash (Table 1).

Market Risk - the risk that equity or fixed interest markets will decline in value. The stockmarket is influenced by investors’ changing expectations of the economic outlook as well as that for individual companies; and the fixed interest market is influenced by expectations about official interest rates and inflation. For example, during October 1987 the Australian All Ordinaries Index of share prices dropped by 42.1%; and, in the first half of 1994, the Australian fixed interest market dropped by 6.4%, although in the following years both recovered strongly (Table 1).

Specific Risk - investing in only a single security can increase the risk of loss. Investors who own shares in just one or two companies are unable to offset the risks of unexpected poor performance by those companies that a broadly diversified portfolio would enable. Similarly, investors who believe that there is no risk associated with government or government-guaranteed bonds can often be disappointed if interest rates rise and the capital value of those bonds is reduced as in 1994.

Currency Risk - a change in the value of the Australian dollar will impact the return on international investments, whether in shares or fixed interest securities. If the Australian dollar appreciates as sharply as it has recently, then the total return on the investment could even be negative for a time, despite a rise in the underlying value of the asset. (This risk can be offset by currency hedging but at a cost).

These risks can best be managed over time by an investor through the clear identification of investment objectives and time horizons, as well as effective oversight of investment decisions.

There are many other risks that may not be foreseen but can undermine the confidence of investors and disrupt markets, resulting in lower returns; the collapse of major businesses (which can include financial institutions and therefore involve the possibility of default risk for investors who may have apparently ‘safe’ deposits with them), terrorism, war and disease are just some examples from past and recent experience. In periods of extreme stress or crisis, all asset returns can suffer and even the historical pattern of relative returns can be distorted.

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3. The principles of asset allocation

Effective asset allocation comes from an understanding of the different asset classes and the risks associated with investing in each. The most appropriate asset allocation is unique to each individual investor, and based on a range of factors including importantly:

Objectives and time horizons,

Risk tolerance, and

Financial situation.

Investment objectives and time horizons

In broad terms, investment objectives typically seek to maximize returns over some period while controlling risks. Since there is no universal definition of risk, investment objectives should seek particularly to identify and address those risks specific to a Diocese.

In order to be effective, investment objectives must be communicated to and understood by all interested parties . Within a Diocese this would include not only those involved directly in the process of deciding and overseeing investments but also those who bear the ultimate risk of their decisions. Effective communication requires investment objectives to be:

Measurable (quantified), Achievable (realistic), Clearly communicated (defined), Relevant (appropriate time horizons), and Consistent.

It is also important that these objectives be reviewed as circumstances change. In the case of a Diocese, for example, this might occur as a result of an unexpected reduction in income as a result of changed economic circumstances that means the existing balance between investing for growth or income will also need to change. Understanding risk tolerance

There is no simple answer to how an investor’s risk tolerance will affect asset allocation. It takes time - and some experience with investing - to understand and accept risk, in particular the willingness to ride out short-term market fluctuations in pursuit of long-term gains.

Investors with similar goals and time horizons could choose different asset mixes depending on both their financial situations and views on risk.

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Determining current and future needs

A Diocese’s current and future financial situation should always be considered when deciding on an investment portfolio.

Current Needs

It is usually important to have access to some part of any investment portfolio for “emergencies” or unexpected short-term expenses.

Where should short-term funds be invested? Bank deposits or short-term bank bills can easily be converted to cash to cover emergency needs. While shares and longer term fixed interest funds can usually be easily accessed, the greater volatility in their market prices means that a capital loss may be incurred if circumstances require an urgent sale of these assets.

Investors who do not have a suitable investment option to meet short-term cash requirements often find it difficult to stick to their long-term investment objectives.

Future Needs

Having decided on the relevant investment horizon and made plans for emergencies, it is necessary to consider the needs for capital growth and income over the longer term. This would obviously be done within the framework of the goals and priorities for Christian mission within a Diocese.

The appropriate time horizon will vary from Diocese to Diocese but, as for all investors, the longer the time horizon the more short-term market fluctuations can be accepted. Also, the longer the time horizon, the greater the market risk that can be assumed as a trade-off for higher returns (see Chart 1 and Table 1). However, only an investor who continues to monitor the progress of a portfolio over time will be able to accurately assess the need for changes to its strategy when circumstances change.

The experience of the past year or so provides a very timely reminder in this respect. While all investors suffered from the extreme volatility in markets, and the increased uncertainty about the economic and political outlook, equities were particularly hard hit. Investors in domestic and overseas shares experienced substantial losses in the capital values of their shares, some of which have substantially recovered as a result of recent strong rises in equity markets. Only those investors with well-developed short and long-term objectives were likely to have made informed decisions about whether or not to change their portfolios over this period.

Investment constraints

All investors have some constraints that will affect their overall investment objectives. In the case of most families, for example, it is ownership of their home, which despite being their principal long-term asset, is often seen as a goal in itself and quite separate from their “investments”.

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For Dioceses, such constraints can include historic buildings, endowments and trusts (especially those with specific conditions attached to their use), and ethical charters that preclude investment in certain businesses or areas of economic activity.

Such constraints should be identified and monitored as part of the investment oversight within a Diocese. In the case of ethical charters, they would be explicitly incorporated into its investment objectives but in other cases, such as historic buildings, they are often best managed separately from other investments.

The consolidation of investment funds

In most cases, however, it is preferable to consolidate all available funds into one portfolio, which can then be invested in accordance with the Diocese’s objectives and on the time horizons decided. Attempts to manage investments separately can often lead to confusion in investment goals, particularly when a variety of small amounts are involved, substantial inefficiencies in oversight and management, as well as an unnecessary increase in fees and charges if managed by independent advisors.

Decision-making and oversight

There should be a clear process of oversight and reporting of the investments of a Diocese, even those that may be regarded as ‘passive’ in nature. A particular example of the latter is buildings and other church property, which, if they are to contribute effectively to the mission of the church, need to be regularly reviewed not only in terms of their physical condition and maintenance needs but also their appropriateness to support specific mission goals.

An appropriately constituted Investment (or Asset Allocation) Committee might be the most straightforward way to achieve such oversight. This process should include senior Diocesan officials but can often benefit from the participation of outside advisers who are able to add not only experience but specific expertise to the process. A properly constituted Diocesan Audit Committee could also be an important component of oversight within the Diocese (see the model Charter for Diocesan Audit Committees that was endorsed by Standing Committee of General Synod at its meeting on 9-11 November, 2002, and circulated to Dioceses later that month).

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4. Constructing an investment portfolio

There are many factors which impact on optimal asset allocation, including:

Realistic Expectations

Past investment performance is no guarantee of future results. In the 1990s, both Australian and international shares recorded strong returns (Table 1). But many commentators now argue that market price to earnings ratios are historically high, meaning that shares appear overvalued. This would suggest that for the foreseeable future, there could well be lower returns from shares. This paper does not attempt to predict the future direction or strength of shares or other assets, but does recommend that Dioceses should set realistic expectations for future returns and risks when managing their investments.

Timing Risk

When it comes time to invest, many investors hesitate because of fears of market fluctuations. The risk associated with having a precise ‘market timing’ strategy (picking the right time to invest) is high. Hoping to take advantage of fluctuations in market values might sound ideal but, in reality, very few investors, if any, can accurately foresee the short-term direction of markets. Investing over time on the basis of sound objectives, and then ‘staying the course’, is usually a better long-term investment strategy than attempting to second guess market timing.

Hints on Implementation

Creating an investment mix that suits specific needs will take careful consideration and planning. Once a Diocese has identified an asset allocation (with or without professional advice) that suits its long-term objectives, the next step is to choose the investments within each asset class. Many Dioceses will find outside professional advice the most effective way to build a diversified portfolio. That advice is often included in the general advice offered by managed funds.

If a range of investments already exists, the assets should be listed at their current values (and returns) and compared to the proposed asset allocation of the new portfolio. Decisions can then be made about how to best adjust the mix of existing investments by selling assets that are over-represented and/or buying those assets needed to obtain the ‘target’ allocation.

Managed Funds

Consideration should be given to using managed investment funds to build an investment portfolio, particularly if investing for the first time. Managed funds are based on a simple idea - investors put their money into a pooled fund, which invests on their behalf in various securities according to the fund's stated objectives.

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Benefits of managed funds include:

Diversification - A managed fund may invest in a broad range of securities, providing easy access to a diversified portfolio.

Management - Professional managers monitor the funds on a daily basis, saving time and money. Economies of scale often provide lower brokerage costs.

Convenience - Managers provide regular statements and reports on all transactions and investment returns.

Liquidity - Investments in a managed fund may be readily sold.

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5. Evaluating and reviewing investment managers

Generally, fund managers are assessed on the following criteria:

Investment Philosophy

An investment manager’s investment philosophy represents the firm’s core set of investment beliefs. Having a logical and defensible investment philosophy is a prerequisite to being a successful investment manager. If an investment manager cannot clearly explain its investment philosophy, it probably doesn’t have one.

Organisational Issues

An examination of the quality and stability of the manager’s employees, how well they work together, the stability of its ownership structure and the structure of performance incentives for its investment professionals is essential, as is a review of its total funds under management. However, depending on the manager’s investment style, bigger is not always better (some management styles lose some of their effectiveness once funds under management exceed a certain level).

Investment Process

A review of the manager’s day-to-day investment process, including how it makes investment decisions, manages currency (in the case of international investments), and how individual stock decisions are made should also be undertaken.

Combining Investment Manager Styles

An investment manager’s style is the process the manager uses to make investment decisions, and can be broadly characterized as passive or active (see the diagram on the following page).

Different investment styles tend to excel at different times under different economic and market conditions, and all investment styles may underperform at some time.

By combining a number of complementary investment styles in the one portfolio, the overall return of a portfolio can be less volatile. Ideally, when one manager is going through a period of underperformance, another manager who is performing well will offset this.

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Reviewing an investment manager’s performance

Assume a managed fund sends out annual statements to its unit holders reporting an 8.5% a year return for the past five years. It is difficult, from this number alone, to judge whether this is a satisfactory performance.

One way might be to compare the return with other managed funds. However, such comparisons do not necessarily indicate now well a particular investment manager has actually performed. Their returns might be higher, although largely as a result of luck rather than the quality of their investment decisions (increasing the likelihood of relatively poor returns in the future).

It is the comparison between the actual return from a managed fund (or portfolio) and the return that could have been generated from the assets it has invested in that indicates whether any fund has performed well, or not.

For this purpose investors and fund managers set benchmarks as reference points against which to check their progress. A benchmark is useful provided the correct benchmark is adopted.

Whatever benchmark is adopted, three questions need to be answered to assess whether or not an investment return is “good”:

a) Where is the fund invested?b) What are the benchmarks for each asset class?c) Did the investment manager outperform or underperform those benchmarks?

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6. Fees and charges

Professional investment management is not free. Hence, when considering managed funds it is important to be aware of all the fees that are charged, as over time, they can diminish total returns.

There are different types of charges an investment manager may charge.

Some managed funds have an upfront charge. Up to 5% of the amount invested is provided for in most prospectuses for retail funds, largely to pay sales commissions to the financial advisor. Alternatively, there may be an exit fee of up to 5% if withdrawals are made within a prescribed penalty time, usually within three years.

For a wholesale investor, however, this fee can be substantially lower and of the order of around 0.7%. While the size of investments to justify treatment as a wholesale investor will vary between managed funds, Dioceses that have a portfolio of around $500,000 will usually qualify as a wholesale investor.

Every fund charges ongoing annual expenses to cover both the investment manager's costs and the costs of operating the fund - custody and accounting charges, legal fees, GST etc. The Management Expense Ratio (MER) is the annual fees and costs expressed as a percentage of assets.

To illustrate, the average annual MER for different managed funds is:

Australian Share Funds - 1.78% International Share Funds - 1.95% Diversified Funds - 1.72% Cash Management Trusts - 1.04% Australian Fixed Interest Funds - 1.38%(Source IFSA, August 2001)

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7. Possible investment portfolios

The investment portfolio’s detailed below are examples only. They are provided as general information about investments. Dioceses should seek professional advice before making informed investment decisions.

Cash Capital Stable Balanced

Typical Investment Objective

Capital Guarantee Beat inflation Return matching Bank

Bill Index

Beat Inflation Exceed average return

of competitor funds

Beat Inflation Exceed average return

of competitor funds

Sources of return

Yield on cash and short term debt securities

Mainly income yield from fixed interest securities. Small scope for capital gain or loss

Income from equities and debt securities. Potential for capital gain or loss

TypicalInvestment

Time Horizon

ShortLess than 1 year

Short – Medium2 - 5 yrs

Medium to Long Term5 – 15 yrs

Typical Split: Growth v. Defensive

Asset Classes

0:100% 30:70% 50:50%

Typical Asset Allocation Mix

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Growth High Growth

Typical Investment Objective

Beat Inflation Exceed average of

competitor funds

Beat Inflation Exceed average of

competitor funds

Sources of return

Income from equities (dividends) and fixed interest securities. Considerable potential for capital gain or loss

Some Income from equities. Large potential for capital gain or loss

Typical Investment

Time Horizon

Long Term10 – 25 yrs

Long Term10 – 25 yrs

Typical Split: Growth v. Defensive

Asset Classes

70:30% 100:0%

Typical Asset Allocation Mix

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