Investing for charities

10 November 2020

Melanie Roberts, partner and investment manager at Sarasin and Partners, considers the key risks facing charities’ investment portfolios today.

‘The value of your investments can go down as well as up.’ Most of us are familiar with this risk warning that investment professionals are required to add to their investment products when marketed to retail investors. But the assessment of risk in the context of charities’ investments needs to be explored much more thoroughly, with risk meaning different things to different people and, in the case of investment, often complicated by risk statistics which need careful interpretation. Risk is dynamic, it needs constant monitoring. Whilst it can be helpful to study historic data and the risks of today might well be similar to those of tomorrow, we need to be prepared for the unexpected.

We strive to ensure that our clients are never surprised by our performance. By achieving a thorough understanding of our charities’ assets, liabilities, return objectives and risk tolerance – and reviewing these regularly – we seek to put in place robust strategies that will meet clients’ objectives under a wide range of scenarios.

Sadly it is estimated that charities are facing a £12.4bn drop in income[i] this year as a result of the coronavirus pandemic. Just when charities need income most, they are losing it from all angles. Charities with investment portfolios are looking at global dividend cuts of 17%, with the picture even worse for UK-only equity portfolios.[ii] Whilst few of us could have predicted the extent of the impact the virus has had on charities’ investments, there are a number of factors we can incorporate when planning.

Inflation risk
This is the risk that inflation gradually erodes a charity’s spending power over time. If we look back over 100 years, inflation in the UK has averaged 3.7% a year[iii] and whilst inflation poses little risk in the near term (August UK CPIH was 0.5%, down from 1.1% in July)[iv], we need to put it in the context of even lower returns available from other assets such as bonds and cash. Hence the steady decline in the value of cash for any length of time. For this reason, holding too much cash can become a risk.

So how can we best ensure a charity’s investments will at least keep pace with and ideally grow ahead of inflation? The answer lies in ensuring the portfolio includes sufficient ‘real’ assets. In the main, these are property and public or private equity, assets whose values are closely aligned to the underlying economy in which they operate. In the case of equities, the fact that companies are generally able to pass on price increases to their customers makes them the ideal real asset.

Volatility risk
Volatility of prices in a marketplace is perfectly normal. Indeed it is regarded as a source of profit for investors who actively exploit volatility when investing. But a golden rule of investment is never to be a forced seller of your charity’s investments at the wrong point in the cycle. Most investments will display volatility at some point, or worse still, become illiquid, meaning there is no buyer of your investment just when you need to sell it. Most property funds today have enforced trading restrictions because of uncertainty relating to the virus; by June, for example, an estimated £10bn was locked up in the largest UK property funds[v]. Equities can experience sharp falls similar to those we witnessed in March this year; any charity needing to liquidate their portfolio incurred heavy losses.

Managing volatility and liquidity risk comes down to prudent planning. Monies needed in the short to medium term should be held in defensive assets. Matching reserves with liabilities is critical and should ensure you do not have to sell after a fall in markets. Longer-term monies can be tied up in more volatile investments, ideally with a time horizon of greater than five years, which is considered enough time for an economic downturn to recover.

Income risk
Although the equity risk premium (the yield achievable from equities compared to that of government bonds) has reached historic highs, it has become more difficult to achieve income from reliable and diversified sources. Many charities rely heavily on the income receipts from their investment portfolio each year and the risk of this falling significantly needs to be avoided. Historically it has been the UK equity market that has offered the highest dividend yields. Yet many of these high yielding shares have come unstuck and sectors such as oil and banking have slashed their dividends in the face of the pandemic.

Ideally charity portfolios should always aim to seek sustainable income streams, investing in companies that strike the right balance between paying out some of their income, but investing enough to grow steadily in the future. Diversification across industries, geographies and asset classes can also help to dampen income volatility. COVID-19 has had less of an impact on those charities with a more international approach and commensurately lower domestic UK exposure.

However, as has already been noted, overseas assets often yield less than UK investments and some of the more defensive asset classes also currently offer paltry income yields. As a consequence, many charities now adopt a total return approach where an agreed portion of capital can be withdrawn each year, reducing the charity’s reliance on income and allowing for a more diverse portfolio.

Reputational risk
The risk of discovering that your charity’s investments contradict your objects can damage a charity’s reputation. Ethical investing today has accelerated well beyond excluding investment in offending industries. Whilst still relevant to impose ethical restrictions, charities’ investments are coming under scrutiny from other angles: environmental, social and governance (ESG) factors being the most pertinent. These are identified and researched across investment markets and companies are either lauded for their clean slate, or slated for their improper practices.

How to avoid such a risk is best managed through a combination of strong dialogue with your investment manager, knowing what you own and being realistic when setting your investment policy. Regulation in this area is supportive and improving with one such European disclosure, the Sustainable Finance Disclosure Regulation, which will apply from March 2021. It is important to appoint a manager that can demonstrate a sound ESG process with clear disclosure and reporting, acknowledging that this remains in its early stages.

These are the main risks we see charities facing with regards to their investment portfolios. Whilst we can never remove risk altogether, having a sound strategic plan and identifying the most likely risks can help to ensure trustees are not surprised by the results. Trustee boards and investment managers must work together to understand and minimise the risks they face.

[ii] Janus Henderson Global Dividend Index Edition 27 August 2020
[iii] Sarasin Compendium of Investment, UK RPI 1900 to 2019
[iv] Office for National Statistics, August 2020

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