The
stock market’s current trends and fads can exercise
an unhealthy fascination for all but the most seasoned investor.
Witness those that lost out twice during the dotcom boom;
firstly by not having tech shares in their portfolio when
values were rapidly rising, and secondly by belatedly adding
them just as the bubble burst.
For trustees of charities and non-profit organisations choosing
their asset allocation strategy, it’s important that
they make decisions removed from such a feverish environment,
says David Kidd, chief investment officer at Arbuthnot Latham.
In most cases, the charity’s long-term needs will be
the main consideration. Investing in cash and bonds has much
to commend it as part of a diversified portfolio; unfortunately
it doesn’t provide a guard against the continual eroding
power of inflation. Many charities, particularly those where
labour costs make a heavy demand on income, suffer a level
of inflation well in excess of the two per cent to 2.5 per
cent rate indicated by the consumer price index.
This explains the popularity of an absolute return strategy,
which involves investing for a return that outpaces inflation.
Over the past 10 years, property takes pole position as the
best-performing asset class, although returns over the coming
decade are generally expected to be more modest.
So what is the critical first step for trustees of charities
and not-for-profits in determining their asset allocation
strategy? A good starting point would be to determine what
their organisation needs money for, suggests Andrew Hunter
Johnston, head of the charities team at BlackRock Investment
Management (UK).
Capital fund objectives range from building up a disaster
reserve or establishing a buffer fund for regular fluctuations
in income, to ensuring that a foundation can continue in perpetuity
and be handed over intact to the next generation.
“Articulating your immediate commitments and aspirations
means you can sharpen up a definition of your objectives,”
says Hunter Johnston. “If bills have to be paid promptly
and ready cash is required, then you don’t want to be
in something illiquid. On the other hand, a long-term endowment
enables you to pursue a longer-term strategy, such as investing
in private equities or property.”
“Aim to work out what your objectives are and how much
risk you are ready to take on, while also reviewing how the
markets have performed historically,” advises John Hildebrand
of Investec Asset Management.
While long-term funds can assume a greater degree of risk
and diverge from the benchmark, shorter-term operational charities
will have their bias towards cash and money market funds.
Asset allocation strategies reflect a charity’s attitude
to risk, ranging from a passive process to an active one that
adopts various levels of risk. In many cases, the trustees
will opt for assets likely to provide income growth over time,
so the benefits can be shared between current and future beneficiaries.
What’s on the menu?
So what other allocation strategies are available? The basic
menu is as follows:
Strategic asset allocation: a method that follows
a ‘base policy mix’, by which a proportional
combination of assets is based on expected rates of return
for each asset class.
The trustees would decide at the outset what rate of return
they anticipate from a specific asset class, while checking
its historic volatility to determine how much money might
be lost should its performance fail to live up to expectations.
If stocks have provided a 10 per cent annual return and
bonds five per cent, then an allocation divided equally
between the two classes would be expected to give a return
of 7.5 per cent per year.
This method usually adheres to a buy-and-hold strategy,
although the policy mix established at the outset will be
adjusted by the subsequent shift in the values of assets.
This might suggest a shift to constant-weighting.
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Constant-weighting asset allocation: under this
method, the portfolio of assets is regularly rebalanced,
so if one asset declines in value then the holding can be
increased, and if it increases in value it can be sold.
For example, at the outset the split might be 70 per cent
equities, 10 per cent property and the remaining 20 per
cent a mixture of bonds and cash, but would change if one
asset outperformed another.
The timing for a rebalancing generally follows the rule
that the portfolio should return to its original mix when
an asset class moves more than five per cent in either direction
from its original value. This carries the potential drawback
that rebalancing may be carried out too frequently.
Tactical asset allocation: this is a more flexible
strategic approach, which allows for short-term deviations
from the usual asset mix to take advantage of unusual or
exceptional investment opportunities.
If based on a rational system, tactical works well. For
example, if a particular market appears particularly cheap
in the short-term, perhaps because economic conditions favour
a particular asset class, the strategy allows the asset
manager to take advantage of this.
The strategy is based on a return to the overall asset mix
once a short-term profit has been made, which requires the
trustee to be alert to when the short-term opportunity has
run its course and it is time for the portfolio to revert
back to its original mix.
Dynamic asset allocation: this is a strategy based
on regular adjustment of the asset mix, as markets rise
or fall and the economy enjoys growth or enters a recession.
Dynamic asset allocation is the opposite of constant weighting
in that assets that are declining are sold, while those
appreciating are bought – stocks would therefore be
sold when it enters a ‘bear market’ in anticipation
of further decreases and bought when a ‘bull market’
prevails in anticipation of further gains.
Insured asset allocation: this approach is suited
to investors who are comfortable with only a low level of
risk, but want the combination of active portfolio management
and the safety of a guaranteed floor, below which the portfolio’s
value cannot fall.
It works by establishing a base portfolio value at the outset,
below which the portfolio should not be allowed to fall.
The trustees exercise active management while the portfolio
value remains above the base level. Should it fall back
to the base value, the strategy switches to one of investing
in risk-free assets in order to fix the base value and to
allow time to review a re-allocation of assets, and possibly
a complete change of investment strategy.
Insured asset allocation can take a formulaic approach,
under which the lower the portfolio value falls so the proportion
of risk-free assets increases – ultimately being entirely
investment in risk-free assets should it decline to base
level. Alternatively, a portfolio insurance approach preserves
the base capital through the use of put options and/or futures
contracts.
Integrated asset allocation: this is a broader
strategy, based either on dynamic asset allocation or constant
weighting allocation, which takes into account investment
risk tolerance in addition to expectations for future market
returns.
Structured products: these offer investment with
an element of capital protection. At the end of the investment
period, the return will be at least the initial investment
and could see the capital value considerably enhanced. There
is, however, no underlying income provided over the investment
period.
In for the long-term
For those able to invest over the long- term, a study of
how the UK markets have performed over the past 20 years
offers some interesting statistics, says Investec’s
Hildebrand.
Based on the FTSE All Share index (which was launched in
1986), the worst annual return in any single year over this
period was a loss of 30 per cent and the best performance
was a gain of 60 per cent. Comparing five-year periods,
the worst performance averaged a loss of 6.5 per cent per
annum and the best provided a gain of 20 per cent.
However, anyone retaining their share portfolio for 10 years
or more will have enjoyed gains – the worst performance
still provided a gain of 5.5 per cent per annum while investing
for 10 years when the market enjoyed a prolonged ‘bull
run’ provided an average of 17 per cent per annum.
“The figures tell you that volatility is reduced the
longer you hold on to equities,” observes Hildebrand.
“Investing over one year only probably isn’t
worth it, as it carries too high a degree of risk, whereas
over 10 years taking on risk is a more attractive proposition
as it’s far less likely you’ll make a loss.”
In the past few years, charities have also begun to overcome
their reluctance to consider non-traditional asset classes
and to invest in hedge funds to further diversify risk,
says Hunter Johnston – a development helped by Cazenove’s
launch of a fund of hedge funds specifically for charities.
“We’d advise investing in a mixture of hedge
funds, rather than a single fund, in order to diversify
risk,” he adds.
Private equities, which Arbuthnot Latham’s Kidd suggests
need a commitment of at least 10 or 15 years, are also on
the agenda. “A large number of private equity funds
are US-based, so currency fluctuations are a factor that
needs to be considered,” he adds. “But more
charities are now looking at them, whereas only the very
biggest would have considered them a few years back.”
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