EquitiesMay 20 2015

Risk, and you shall receive

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Risk, and you shall receive

A popular misconception is that charities are very conservative entities, averse to taking risk. After all, the assets that are entrusted within charities are for the benefit of the public and the specific beneficiary that the organisation supports.

Trustees of a charity have a duty of care and prudence over the assets of a charity. They should avoid undertaking activities that might place the charity’s endowment, funds, assets or reputation at undue risk. It is not uncommon for trustees to have a lower risk attitude while they are serving the charity as they ‘do not want anything to go wrong on their watch’, but in reality, charities can and should take risk where it is appropriate to do so.

Charities share some attributes with pension funds; both are regulated and have an obligation to meet the needs of current and future beneficiaries, but there are also a few significant differences. While pension funds have defined liabilities relating to the age and payout of the pensioners, charities are mostly around for a very long time or in perpetuity.

They have a very long-term investment horizon, and while they do not have defined beneficiaries, charities that have surplus capital from daily expenditure will wish to protect the real value, at least in line with inflation over time. Therefore an investment into real assets, such as equities and property that participate in the real economy, is likely to achieve the need to have sufficient funds to meet their long-term charitable objectives.

The contrast between the long-term horizon of a charity, the shorter-term behaviour of a trustee and the current economic climate is apparent in recent research on UK charities.

As many as 41 per cent of charities are concerned about their performance over the next 12 months, reflecting short-term financial concerns and typical trustee behaviour. As a result, charities are focusing on risk when managing their investment portfolio. Indeed, 62 per cent of charities believe risk is the most relevant metric when managing an investment portfolio, while 33 per cent claim return and just 7 per cent state it is yield.

Notwithstanding market falls in 2000 due to the dotcom bubble and the credit crisis in 2008, and despite current global economic uncertainty, charities continue to invest in equities to deliver effective market returns. More than 81 per cent of charity portfolios were invested in equities, with bonds and property equal second at 56 per cent.

It is notable, therefore, that despite increasing levels of market volatility, the majority of charities remain allocated to equities. This underlines their long-term investment horizon and the fact that trustees, in general, view equities as medium risk, while financial regulators regard them to be more risky.

Interestingly, while charities are happy to invest into equities, more than 69 per cent of charities target ‘inflation plus’ return for their investments with 38 per cent targeting a combination of market indices. As many charities employ staff and need to keep pace with wage inflation, the retail price index is often seen to be the more appropriate measure. By adopting an inflation-based return requirement, the overall portfolio of investments can be relatively unconstrained by the type of assets that are employed to achieve the aim.

Targeting a combination of market indices or using a market-based benchmark as a reference for investment performance indicate charities are prepared to take more risk.

A natural concurrence of this approach is that the underlying investments are likely to be more constrained to match the benchmark; therefore, holding assets in both rising and falling markets makes overall portfolio returns more volatile in the short-term. Three quarters of the charities surveyed use a market-based benchmark to compare investment performance, while 44 per cent of charities said they used an absolute-based benchmark.

The fact that charities believe risk is the most relevant metric when managing an investment portfolio is telling. There are a number of factors that possibly underlie this statistic if we look beyond the obvious duty of prudence. Trustees are becoming more understanding of the relationship of risk and return. As charity investments get ever more global in outlook, investing in multiple asset classes highlights the importance of appreciating the relative risks being taken.

Charity investment managers are more open with risk and displaying various measures of risk in their regular reports to trustees. The increase of charity peer-group indices has extended the focus on risk-based investment returns, with the likes of Asset Risk Consultants now producing regular analysis of risk-orientated charity indices for the UK charity market. These factors are enhancing a trend towards risk-based investment factors.

The fact that charities are concerned with their short-term performance is also a reflection on the current low return environment. Charities that currently have relatively high-income needs are taking increasing levels of risk in a low interest-rate world.

Following the trend to invest in excessively low yielding fixed income assets and shares in expensively priced companies paying a higher dividend yield, charities run the short-term risk of capital loss if interest rates rise. In these circumstances, charities are likely to be more reliant on their endowment investments to meet the ever present requirement to balance the needs of current and future beneficiaries.

Returning to the long-term investment nature that charities display, provided a charity has sufficient short-term cash to meet ongoing capital expenditure and liquid reserves to meet likely charitable expenditure for the next six to 18 months as appropriate, longer-term investments can and should be put to risk.

The need for short-term liquidity caught some charities during the credit crisis. For example, larger US endowments have historically bought illiquid assets such as physical property and private equity investments for long-term capital gains. Not only did Harvard and Yale endowments witness portfolio declines of -27.3 per cent and -24.6 per cent respectively in 2008/09, they became forced sellers of liquid assets to meet short-term funding needs. Of course, these endowments have recovered their market values since that point, but it highlights the need to have sufficient liquid assets to balance the longer-term higher risk attitude.

Other risks that charities and their trustees need to consider include reputational risk, investing in areas that might have a negative impact on the donors or beneficiaries of the charity. Recently, there have been high-profile examples of charities investing in sectors such as tobacco, alcohol and arms firms that may contradict their core values.

In conclusion, charities need to be prudently governed. Trustees need to have considered the relevant issues in making investments, taken advice where appropriate and reached a reasonable decision. Provided they make provision for short-term spending needs, trustees are unlikely to be criticised for their decisions when adopting a particular investment policy in meeting the long-term investment requirements of the charity, and fundamentally take risk where it is appropriate to do so.

Guy Davies is head of charities at Heartwood Investment Management

Key points

Charities share some attributes with pension funds: both are regulated and have an obligation to meet the needs of current and future beneficiaries.

More than 69 per cent of charities target ‘inflation plus’ return for their investments.

Trustees need to have considered the relevant issues in making investments.