The panellists

Paul Palmer (chair)	Nigel Davies	Ron Clarke
Cass Business School professor of voluntary sector management	Charity Commission deputy head of accountancy policy	Esmée Fairbairn Foundation finance director

Heather Lamont	Ben Palmer	Andrew Pitt
HSBC Investments head of charity business	Schroders charity strategist	UBS executive director

If there was one thing on which all of the panellists at Charity Times’ first investment roundtable agreed, it was that the investment landscape for charities is a completely different animal than it was even 10 years ago.

Gone are the days when a beauty parade turned up four investment managers, all pitching a direct investment equity portfolio and a bit of bonds. Strategies are becoming ever more sophisticated to effectively match the investment goals of individual organisations with individual charitable aims, and this is reflected both by investment managers and the charities they serve.

A major theme raised in the discussion was the need for a holistic approach to investment, and a realisation that effective investment strategy cannot be achieved in isolation. This means linking strategy to reserves policy, charitable purposes and appetite for risk, as well as moving from a peer group approach and adopting more bespoke strategies and individual benchmarking.

Also highlighted was the increasing prevalence of total return investment styles, as well as the need to think realistically about individual measures of inflation.

All in all, this new investment universe could be a bit daunting for the uninitiated, with a huge range of factors to consider if a charity is to provide the equivalent of ‘shareholder value’ to its beneficiaries.

These include getting the right mix of assets, understanding risks and taking full account of short-term income potentially eroding a long-term strategy for growth. It is also taking account of a full strategy, rather than relying on, say, picking a couple of good stocks that worked well in a mate’s personal portfolio.

Asset mix – the long and the short of it

“The famous Brinson study, as well as a number of studies over the past 20 or 30 years which back this up, says that portfolio performance is determined by how you asset allocate – how much in equities, bonds commercial property etc – it actually has very little to do with if you are good at timing in and out of the markets or with individual stock selection – for example, is it better to choose BP or Shell? These things make very little difference in fact,” says Andrew Pitt.

Of course, every charity will have its own reasons for investing, and its own desired outcome, so in terms of actually deciding on what is appropriate allocation, Heather Lamont offers a three step approach in the first instance. “Look at your own charity’s objectives and tie that in with the other factors in play,” she says. “It comes down to: what are the objectives; then what’s the policy; and then what’s the asset allocation – then you can start worrying about what the benchmarks are going to be, for example.”

In simplest terms, this comes down to the dichotomy between long and short-term, both in actual returns and as a matter of perception. Ron Clarke says that in the long term, his organisation will be able to cope if markets go down, but in the short term losses will impact on how trustees view the portfolio – which is, of course, negatively.

Because of this, says Clarke, dealing with that dichotomy and determining the right asset mix for the portfolio is not a one-off. He describes it as an evolutionary process, starting at a point where trustees feel comfortable at a level of risk with available products, and then gradually diversifying as is acceptable. “You have to start by thinking about what your objectives are, before determining which asset classes you are actually bringing in, and unless you do that, there is always the danger that you will lose the bigger picture,” he says.

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Nigel Davies agrees, saying the process is by no means static. He points out that objectives change, as do responses to the market, and that generally operational charities and grant making trusts, for example, will have very different dynamics to their review process.

Ultimately, though, this process comes down to risk versus return, and as Ben Palmer points out you can really only control one of these parameters in your portfolio. “If it is return then you target return and you understand what that means in the short-term in terms of risk exposure,” he says. “If you want to control risk then you control risk – so if you have a particular loss tolerance or you want to operate within a particular volatility measure, then you structure a portfolio to do that while understanding how that may compromise the longer-term return objective.”

Palmer believes that the corner stone for charities seeking long-term returns in excess of inflation, and being able to distribute to beneficiaries while growing capital ahead of inflation, is equities. The proliferation of alternative asset classes in recent years, he says, has served to maximise the risk/return trade-off, and not necessarily to maximise returns.

“There will always be a trade-off with long-term objectives and what’s feasible in short-term experience,” he says. “No one wants to be a trustee handing over a portfolio that’s fallen in value by 30 per cent since they took it on, so there’s always that potential conflict.”

Andrew Pitt furthers this point, saying that time horizon is absolutely key. “If we go back to 2003, many charities which claimed to have very long-term time horizons were fretting about the fact that they had lost, say, 40 per cent of their endowment over a three year period because equity markets had had such a poor run. But they were forgetting the lessons of history; that over the long term equities in the end will do the job for you.”

Reserving judgement

“One of the obvious issues is how much you are about the beneficiary today, as opposed to the beneficiary in 10 years time,” says Paul Palmer, “and how the Charity Commission views this, particularly in terms of reserves.”

“The principle of reserves is that income funds should be spent within a reasonable period of receipt,” answers Davies. “I think we’ve steered away from any indicative level of reserves. We now look to charities to make their own decisions, but to justify those reserves.”

Ben Palmer says that the issue of “inter-generational equity” is a running theme, where charities potentially differ in terms of favouring the current versus the future. “When we talk about income, which is still broadly thought of by trustees as investment income but more recently, and certainly in a total returns space, income, I think, is really the draw down amount”

Davies reiterates that there is a difference between the total return approach and other approaches to investment. “A charity in a total return situation wouldn’t be caught by that differential in the sense that they could invest their total return, and only that portion of return that is classified by the trustees as income is then spent under a total return approach.

"However the yield from an endowment, not invested on a total return basis, would, if it is unspent, count towards the reserves that we’re talking about. So it very much depends on what the charity’s fund structure is. How much capital it has to invest and how much of its investment yield counts as income.”

How do you solve a problem like inflation?

Once you’ve determined your broad strategy and accounted for reserves, inflation is a factor that can certainly damage a portfolio if it is not accounted for correctly. In reality, this means determining a level of individual inflation, broadly determined by your charitable aims and objectives.

And it is imperative that you get this definition of inflation right, says Andrew Pitt. “If you get it wrong then you could find yourself in difficulty some years down the line. At the end of the day very often charities will have to base themselves not on inflation within goods and services, but perhaps on salary inflation instead.”

Ben Palmer agrees with this, pointing out that charities working in education or medical expenses, for example, are completely out of sync with the Chancellor’s versions of core inflation. “Sustainability is all about sustaining purpose; it’s not about being able to go to Tesco and buy a bag of groceries. It’s critical that charities look at their own rate of cost inflation.”

This comes back to the idea of an overall strategy, in line with the aims and objectives of the organisation. “Grant makers are thinking more strategically than they did perhaps 20 years ago, when they’d shake out the piggy bank on the 31st of March and decide who they wanted to give it to, and the next year you might have much more, or much less,” says Lamont.

Clarke agrees with this, saying that in the past there was thinking that you distributed whatever you received as income, whereas now you define the level at which you wish to distribute and this then feeds investment policy and inflation rate determination. “That has been one of the big changes from our point of view; defining what we mean to be real growth,” he says.

The benchmark issue

Similar to determining personal inflation levels, some organisations are structuring bespoke benchmarks, moving away from peer comparisons. Paul Palmer points out that pension funds have already broadly moved from composite benchmarks because “otherwise you get a herding instinct; you herd towards mediocrity,” he says. “So should there be a single benchmark? We applaud diversity, so shouldn’t there be diversity in charity investment?”

“Effectively trustees have been forced to think about their own benchmarks and forced to confront the issues of risk, inflation and what return they want; those things that before were delegated off to the benchmark,” says Pitt.

“You can operate a bespoke benchmark,” adds Ben Palmer. “If you haven’t found one out there that is compatible with your own framework, then create one. I think it is fair to say that there is a lot more use out there now of bespoke benchmarks than there was 10 years ago.”

And from the Commission’s point of view: “You need to look at your benchmark and the motive for it; what are your portfolio benchmarks and why do you employ them – and I think that’s a decision for the trustees to make with their investment advisors,” says Davies.

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Gaining regularity

A further discussion charities may wish to have with their advisors is how to best produce regular income without damaging their long-term investment strategy. Income generation has traditionally been achieved, mostly, with bonds, but as the investment universe becomes more sophisticated, there are now a number of different potential strategies to consider.

But to begin with, “I would question what we mean by income,” says Pitt. “Do we mean physical interest and dividends and coupons or do we mean ‘we’ve decided we’re going to distribute 3.5 per cent of our endowment on an annual basis’ and we can do that on a total return approach. If it’s the former, you might need to have a substantial proportion of the portfolio in bonds, and that way you’re going to be destroying, in the long term, the real value of your investment portfolio.”

“Modern techniques and innovations in the sector mean that there are other means of generating income,” says Ben Palmer, “and one, that’s fairly common in the US but new to the UK market, is the ‘covered call’ strategy, the use of derivatives – selling options on portfolios of equities. This is another means of generating current income from an equity portfolio and retaining a degree of upside participation, while compromising the full extent of potential upside.”

“We’ve looked at derivatives, and there are two examples in the guidance,” says Davies. “I think the distinction we take with derivatives is that we’re anxious charities don’t move across into day trading and speculation and lose themselves in the investment market, and therefore forget why they’re investing.”

Also, if you’ve got a strict income policy and you can only live on the dividends and interest, then there may be times when you’re actually generating more income than you want, says Lamont. “You then run the risk that you’re sitting on excess income that could be generating higher returns if you thought about things in the long term.”

In practical terms, Paul Palmer gives the example of a charity with a commitment to look after a group of endangered animals. “I’ve got £2 million and a commitment to produce a regular income for the next 15 years; what should I do,” he asks.

“I think I’d find out first whether you are prepared to take a total return approach,” says Pitt. “If you are, then we could have a broader conversation about asset classes, which could include things like hedge funds, whereas if you are completely fixated on wanting an amount of ‘income’ then you’re probably talking about bonds, maybe a bit of commercial property and a bit of equities. But it all depends at the end of the day on the level of income we’re talking about.”

“And timing of expenditure is critical,” says Ben Palmer. “And again that’s why it is important that trustees communicate their expenditure plans to asset managers. We don’t want to reinvest income or cash into the equity markets and then be told of plans to withdraw a significant amount. Ongoing, two-way communication is essential.”

Some final words of advice…

By the very nature of a ‘holistic approach’ to investment strategy, that strategy will differ in some way for everyone implementing it. However, the panellists finished out the discussion with some general words of advice for all charities putting their strategy together.

Ben Palmer says it is important to understand the trade-off between risk and reward, and to look at the full investment universe and potential asset mixes to avoid concentrated risks.

For Andrew Pitt, trustees must consider return time horizons and volatility and work out the inflation rate they are actually dealing with. He also encourages thinking about total return policies and having the confidence to believe that over the longer-term, asset classes will probably perform in the way one would expect based on historical performance.

For Ron Clarke it is the need to be clear about strategy, but also the need to be professional about how that is approached – including thinking about the distinction between governance and implementation.

Heather Lamont says to know what the purpose of your portfolio is, to have a good relationship with advisors, and to ensure trustees have appropriate expertise, both in knowing the issues affecting their charity and charity investments in general.

And finally, Nigel Davies says to let your charitable objectives and activities shape your policy, agree an appropriate benchmark, have a good relationship with your investment advisor, and to keep matters under review particularly in light of your changing objectives and activities.

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