October/November 2013 Investment Analysis: Freedom from constraint

Freedom from constraint

Oliver Wallin argues that a switch to total return mandates could give charities a more effective way of managing risk

FROM JANUARY the Charity Commission is going to allow endowed charities to choose a total return investment approach without having to seek special permission. This is a welcome change, which the Commission has been consulting on since an amendment to the law earlier this year.

Adopting a total return strategy means charities will be able to ask their fund manager to generate a specific level of income, but the money they receive won’t have to be produced as ‘natural’ and fluctuating income from interest and dividends alone. Instead, a charity’s income requirements can be met not just from interest and dividends, but from capital growth as well.

This is all total return is – the combination of all sources of return, which is then accessed in full or part through capital drawdown. The instruction to ‘Keep off the capital’ is being relaxed and with it an obligation that is increasingly more difficult to meet in the current environment of low rates. If charities are willing to embrace this shift in emphasis, they may give themselves a much better chance of meeting both their current and future obligations.

In search of yield
The past was kind to the income seeker. History might tell you that a yield of 4-5 per cent a year was both desirable and achievable, and this is often referred to as an expectation when I speak to clients. History also tells us that the return from cash was around 3-3.5 per cent. But today the reality is somewhat different.

The world has moved on, central banks have seen to that, but it is taking some time to sink in with investors. The plots the yield on 10-year UK government bonds, or gilts, since 1900. There are a couple of things to draw from it.

Firstly, current yields are historically low following a steep and steady decline, and are now hardly keeping pace with inflation. But 4 per cent yields were available only five years ago.

The second is that for more than 30 years we have experienced a bull run in gilt prices, which has resulted in ever-declining yields, a trend accentuated by recent monetary intervention. The result is significant risk to capital when yields eventually begin to rise, as we have seen in recent months.

All in all, it’s not a particularly compelling case for investing in gilts at the moment, but the yields on corporate bonds have not been much more impressive — with interest rates at their current rock-bottom levels, companies simply don’t need to pay much above gilts to raise money on the markets.

Yield seekers are, intentionally or unwittingly, being directed towards higher-risk asset classes, such as junk bonds, emerging market debt, infrastructure and equities in a bid to deliver on their yield expectations — the
so-called reach for yield. This is creating its own issues, with spreads narrowing and investors not really being rewarded for the risk they are being asked to take on.

We’re in an environment where the Rwandan government can borrow money from the markets, for the first time, at 6.75 per cent. In such a market investors need to do one of two things: lower their yield expectations or change the delivery mechanism of that yield.

Greater diversification
If trustees are comfortable to draw down from capital, a much broader universe opens up, one that offers greater diversification and associated risk benefits as well as enhanced opportunities to deliver long-term real returns.

There will be less reliance on a handful of predominantly UK-based asset classes such as gilts and UK corporate debt and, importantly, less reliance on the individual companies in the UK stockmarket that provide the bulk of the dividends paid out of by the FTSE.

BP’s decision to suspend its dividend for a year, in the wake of the Gulf of Mexico disaster, had a major impact on income portfolios of all shapes and sizes. A further advantage is that it can give investors access to the likes of Apple, a strong company in spite of its poor dividend history.

The key point to remember is that the aim with a total return approach is to sell some of the growth an investment has achieved, not necessarily the capital (although that may have to be done in years when growth has been negative). The total return mandate allows the focus to rest on long-term real returns and efficient risk management.

Effective budgeting
Total return enables the trustees to budget more effectively, because they can specify the amount of funding they require each year. They can also determine the frequency — likely to be a very valuable benefit.

In short, a total return approach could free many charities from an artificial constraint and allow them to manage their investment risk in whatever way they decide is best for their particular organisation.

Oliver Wallin is investment director atOctopus Investments

CAF Financial Solutions works with a number of different fund management houses including Octopus Investments to provide funds and services that are specifically designed to meet the needs of the sector.

Visit: www.cafonline.org/investments

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