The global economy is still reeling from the rapid descent into recession, which began with the collapse of the US subprime market and led to the collapse of Lehman Brothers and bail out of other major banking names.

Comparisons with the Great Depression of the 1930s have become commonplace. As the ongoing turmoil seeps through to other parts of the economy – such as manufacturing – the equity markets have continued to slump.

Charities have traditionally invested heavily in equities. Now many are questioning this tactic having seen the value of their investments drop like a stone. As at the end of February, UK equities were down 32.98% on the previous year, while global equities had sunk 27.20% over the same period (see below).

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And it hasn’t just been the last 12 months. “Equity investors have been on a wild, and ultimately, disappointing ride over the past decade,” according to research from Barclays Capital. It found equities were the worst-performing asset class since 1997, with average annual returns of -1.5%.

Andrew Pitt, head of charities and executive director at UBS Wealth Management, thinks it is natural that charities – which have always had a very high exposure to equities – should be throwing their hands up in despair. “Given the events of the past year and a half, I would guess a number of charities can’t believe the extent to which their portfolios have reduced in value given that they thought they were doing what the ‘average charity’ was doing – ie having a relatively high equity weighting,” says Pitt.

So how bad is the current environment and what should trustees be doing about it? We are in a very serious bear market, according to Pitt. “2008 was one of the three worst years for the UK stock market over the last two centuries. And we must be down another 15% year-todate at least.” Volatility is also a big problem for fund managers, with the markets at their most volatile in 80 years.

Riding out the storm

It is natural for charity trustees to think about becoming more conservative in their investments, but that would be the wrong move, says Pitt. Charities should maintain a long-term view on their investments – and that means taking the rough with the smooth. “The UBS view is that clients with very long-term time horizons should always have a meaningful exposure to equities. What seems like a complete disaster at the moment is likely to look like a mere ‘blip’ in 50 years’ time.”

Becoming more risk averse is a natural response to a recession – just as investors’ appetite for risk tends to increase when markets go up. But these natural behavioural responses could lead investors to miss an opportunity. “Some might be thinking they may be less comfortable now with such a big exposure to equities,” says Jim Dunsford, chief investment officer for HSBC Global Asset Management. “But on the other hand equity markets have fallen a very long way and long-term valuation measures are now more attractive because values have fallen so much. If you look beyond the next few quarters it could be quite an attractive place to be for longer term investors.”

Dunsford thinks equities will continue to be the best performing asset over the long term, despite having had a poor decade. “So it’s the wrong thing to do to go too defensive at the moment.” This is not to say that a balanced investment portfolio isn’t still important. He thinks a spread of equity and fixed income investments, with some exposure to alternatives – property or even hedge funds – should provide the right mix. Charities with funds and grants in different currencies should look for a more global investment portfolio.

Bags of diversification

Diversification is the all-important word when it comes to putting your money into equities. As the financial crisis has proved, putting all your eggs in one basket is never a good approach. Another lesson has been the speed at which outwardly solid and solvent companies can spiral downwards.

Quality is still important, but quantity has become more desirable. Investing your money across a large number of highly-rated companies helps to minimise the impact of corporate failure.

Investors will inevitably slip up on banana skins, warns James Bevan, chief investment officer at CCLA. It takes bags of diversification to offer protection from these potential perils. “What we have observed in this downturn are some shockers that nobody could have predicted,” he says. “The severity of the downturn and the extent to which it has crossed from sector to sector and company to company has meant it has been extremely difficult to be wholly confident one has bought only quality.”

“Too many eggs in too few baskets necessarily leaves a charity open to the sorts of risk they can avoid,” he continues. “If you have a couple of hundred investments in a portfolio, you will have very small individual stakes in individual companies – and therefore you can afford for one or two companies to disappoint.”

It’s not all doom and gloom for equity investors. For those charities that take dividends as income, the current environment may not be all that tough. Some charities can only spend income and not capital, unless they get permission from the Charity Commission. For these groups, and others that rely on dividend payments, the weakness of the pound has offered an unlikely bonus. “Interestingly for the UK investor, the dividend yields that are now available do look very attractive relative to cash,” says Bevan. “That puts up quite a quandary for investors to contemplate.”

Diversification is also important for charities that live off their dividends. Only a small number of companies account for the overwhelming majority of dividends paid by UK companies. Until recently, HSBC, Royal Dutch Shell and BP provided 35% of total payouts. But now HSBC has scrapped its dividends while BP – Britain’s largest dividend payer – will stick to 2008 levels in its returns to shareholders. This could be an argument to invest more globally – particularly among companies that pay their dividends in dollars. “If those companies start cutting their dividends and you have anything that looks like a market portfolio you will be in trouble,” warns Bevan. “I do think that investors who are interested in long-term dividend flows to support their charitable programmes do need to increasingly consider a more global approach.”

The right mix

For those trustees looking to give their portfolios a spring clean, there are a number of options beyond straightforward diversification. Investment grade corporate bonds could provide a good alternative to government bonds in the current environment, says Dunsford. “And you could look at shifting towards the higher yielding stocks within equities. There are lots of blue chips yielding 5%, 6% and 7% where we think the income is reasonably secure – that can be looked at within the equity part of the portfolio.”

Bevan agrees that some stocks are still looking attractive. “If I look at Vodafone or Glaxo or AstraZeneca – three of the companies already paying very high dividend – I see companies whose earnings yield is 11% or 12%. That sounds high from companies that have the long term credentials of quality that they all have. Even Tesco has an earnings yield now of 10% and all the evidence is that Tesco is a well run, substantial, robust business.”

Exposure to asset classes that are not highly correlated with equities is also a good idea. The current downturn may have also seen plummeting house prices, but in previous bear markets – such as in the early 2000s – property proved to be remarkably resilient. Hedge funds may have earned themselves a bad reputation for their short selling practices, but this alternative asset class also outperformed the last market downturn.

Ethical investing?

Getting back to the basic principles of ethical investing could also prove worthwhile. One of the culprits of the financial crisis was excessive risk-taking at the major banks, encouraged by a bonus culture that rewarded short term profits over long term stability. “Investing in companies with poor governance practices could be a risk,” says Sam Collin, who leads work at the EIRIS Foundation to increase awareness of responsible investing. Charities that invest in themed funds – such as clean technology, water or waste – can benefit from additional diversification while supporting good corporate values.

And then there’s cash. Don’t leave it languishing under mattresses, says UBS’s Pitt. “One thing charities can think about doing is maximising the returns they can get out of their cash balances. Research done three or four years ago suggested that if charities were able to achieve even half a percent more than they did, they would have generated an extra ten million pounds for the sector.” Granted it is tough to generate an extra half percent yield given current interest rates, Pitt submits. “But with a little bit of thought cash could be put to work just a little bit harder.”

The tough job for most investors is trying to figure out when the market has bottomed. Some experts say we have already seen the worst of the crisis, but there are plenty of reasons to expect further contagion. Once the markets do sense the beginning of the end, equity stocks could rally quickly. “When the bottom was reached in previous bear markets, equity markets recovered to the tune of nearly 40% on average in the 12 months or so after,” says Pitt. “You will potentially get a sharp rerating upwards when the markets begin to sense that better news might be just around the corner.”

Helen Yates is a freelance journalist

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