Nick Murphy: Trustees must address investment risks in good time

Most charity trustees are well aware that stepping out of cash involves some risk to their investment portfolio. However, too often risk is only seen in terms of volatility. We believe investment risk requires a broader perspective to ensure that all potential risks are identified and managed.

First, it is worth noting that risk is not static. Each asset class – and we invest across equities and fixed interest, plus real estate, infrastructure, commodities and other alternatives – has its own characteristics and performs differently in different economic and market environments. Understanding the underlying factors impacting each asset type and the degree of correlation they have in different market environments is another part of the risk mitigation process.

As such, any proper assessment of investment risk needs to incorporate an analysis of the macroeconomic environment. We live in a complex world with a wide variety of economic and market influences. While it is important not to be excessively sensitive to market ‘noise’, these influences have a material impact on the timing and extent of investment returns. Witness the influence of quantitative easing on the fixed income market in recent years, for example.

In particular, it is important to be alert to changes in growth and inflation risk expectations. These drive many of the other risks and the relative performance of all the asset classes: low interest rates have compressed yields in fixed income, driving prices higher. They have also driven growth stocks over the last decade, as investors have sought out sources of secular growth in a climate of weak economic growth.

There are always new risks that are emerging. For much of the past few decades, we would need to be alert to companies’ vulnerability to changes in oil prices. Today, climate change is emerging as another important risk factor. Today, we need to recognise existential factors that could permanently impact a company’s social license to operate, such as poor governance, mistreatment of employees, or failing to address climate change risks. As politics change economic priorities and policies change, regulatory risk rises.

The role of investment managers is to help charities set their long-term investment objectives and then find the right combination of assets for each client’s capacity and appetite for risk. We work with a strategic asset allocation, which reflects long-term expectations for specific assets, and then build a shorter term tactical asset allocation around it to take account of changing market conditions.

This combination needs to be monitored over time. The biggest risk for any investor is that they don’t meet their goals because the combination of assets selected doesn’t perform as expected. As such, trustees need to be alert to whether their investment manager is performing as expected and be wary of any ‘creep’ in their investment process.

Liquidity risk – being able to withdraw your assets when you want to – should also be considered. There will also be operational risks. This may be the robustness of the custodians where the assets are held, the quality of administration, whether the portfolio is exposed to stock lending, counterparty risks or credit risk? Do you receive timely information to enable effective monitoring? Scenario analysis and stress testing can help monitor potential emerging risks.

It is vital to identify and manage all investment risk, not simply the volatility of individual assets. There are a variety of risks that can prevent a charity meeting its long-term objectives and you need to understand and address them in good time.

This article is sponsored by Smith and Williamson Investment Management and written by the company's head of charities, Nick Murphy.

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