Investment issues

BEN JOHNSON, an investment strategist at consultancy WTW, discusses why there needs to be a shift in how charities invest, and sets out how charities should build alternative portfolios.

The last two years have seen a dramatic shift in the landscape for charities and their investment portfolios. For many, a similar shift in thinking is now required in response to a growing cost of giving crisis, difficult investment market conditions, and new and evolving regulations. Let us look at each of these factors in turn:

A GROWING COST OF GIVING CRISIS. The cost of living crisis has meant that many charities are trying to balance increased spending requirements and outgo (in the form of greater calls on their services, higher utility bills, wage pressures and requests for larger grants) with a reduced income from fundraising and donations.

Concerningly, a recent Charities Aid Foundation survey found that 35% of charity leaders were worried about their organisation surviving in the current environment. Many charities are therefore considering drawing down larger amounts from their investment portfolios to plug funding gaps and help meet outgo that can’t be met through regular sources.

DIFFICULT INVESTMENT MARKET CONDITIONS. In the 10 years up to the end of 2021, low and stable inflation and interest rates, high levels of global liquidity and steady economic growth meant that most growth assets experienced significant positive performance, with charities’ investments generally benefitting from this.

However, these factors have changed significantly and rapidly, resulting in global equities falling markedly in value over the course of 2022. This has had real implications for charities given their typically high allocations to equities. Any disinvestments needed to meet outgoings may therefore need to take place at depressed values, locking in losses.

Still volatile years

Unfortunately, the forward-looking picture doesn’t look much rosier. With inflation remaining stubbornly persistent and the economic outlook increasingly precarious, charities may become even more reliant on their investments to meet spending requirements and outgo in future. However, if equity-heavy portfolios are maintained, the value of these pots could see a substantial decline. One expects the next few years to be more like the volatile year of 2022, as opposed to the generally positive-trending preceding decade. So far in 2023 this view has been borne out.

NEW AND EVOLVING REGULATIONS. In addition to a new economic landscape, there is also a new regulatory landscape which charity decision makers will need to consider when formulating their investment policies.

The Charities Act 2022 provides trustees with additional levers to further their charities’ purposes and includes new powers to borrow from permanent endowments (subject to a limit of 25% with any expenditure needing to be recouped within 20 years). This provides charities with an additional option, but also presents a conundrum – how to strike the right balance between giving now, when there is significant need, and capital preservation for the future. This decision is further complicated given the fall in asset values mentioned above.

Social investments allowed

The legislation also allows charities to make social investments (when taking a total return approach to investment) and is in parallel to the much discussed Butler-Sloss case, which provided trustees greater clarity on the use of ethical investments when formulating their investment policy. Further guidance on the latter is expected to be provided from the Charities Commission this summer and will need to be considered by charity trustees.

LOOKING FORWARD TO THE NEW FINANCIAL REALITY. The three challenges outlined above all trigger a need for charities to reconsider their investment portfolios. However, there is clearly a lot for charities to understand before making any decisions about their investments in 2023 and beyond.

From a strategic perspective it is important for trustees to assess whether their investment portfolio is expected to deliver:

1. Sufficient income generation/liquidity and capital preservation to meet near term outgoings.
2. The long term growth needed to support the charity’s mission.
3. Alignment with their charity’s purpose.

No single asset class in isolation is likely to achieve all these objectives. For instance, while a high allocation to equities is expected to deliver asset growth in the long term, in the short-term values can be extremely volatile (as demonstrated over the course of 2022), meaning they aren’t a stable source from which to disinvest to help meet outgoings.

This holds especially true given that the scenario in which disinvestments are most likely to be required (i.e., following a significant drop in donations due to a decline in economic prosperity) is also likely to coincide with a fall in the value of equity markets. Similarly, a high allocation to cash is unlikely to be appropriate too. Whilst this would provide a highly liquid allocation that preserves capital in nominal terms, it wouldn’t maintain asset values in real terms, which is very important when it comes to weathering the current inflationary storm.

Balancing competing requirements

The solution is instead to construct a portfolio that balances all the competing requirements and manages risks both in the short and long term, where risks are considered from many different angles (including sustainability and climate related risks, which are expected to have a significant impact in the coming years).

By doing this, charity trustees can build a portfolio that supports their mission, aligns with their purpose, and is expected to provide both a reliable source of funds for shorter term needs and real capital growth and preservation in the long term. The portfolios most likely to achieve this require:

• DIVERSIFICATION – reducing reliance on any one asset class will deliver smoother returns and a more stable base. Exploring non-traditional assets beyond equity and bonds (such as private markets and less liquid assets) will also support portfolio returns under the current inflationary market conditions. The simple premise is to avoid having all eggs in one basket.
• DOWNSIDE RISK PROTECTION - including assets that are expected to deliver positive performance when mainstream growth markets are falling in value helps provide stability, and is a tool commonly used by many large institutional investors, such as defined benefit pension schemes and university endowments.
• ACTIVE MANAGEMENT – volatile markets provide opportunities for skilled investment managers to outperform and provide a diversified stream of returns.
• SUSTAINABLE FOCUS – there is an ever-increasing focus on securing the long term sustainability of our planet, ecosystems, and society. There are many elements to this, with addressing climate change being a top priority. Many now regard this as an urgent and systemic risk and are changing behaviours accordingly.
  
  This will provide both opportunities and risks for charities as long term investors of capital. Accessing the opportunities and avoiding the risks is expected to deliver improved risk-adjusted returns, as well as alignment with many charities’ purposes.

Such a portfolio is likely to be more sophisticated and deploy capital across more asset classes than is currently the case for many charities. However, it has delivered at times of instability. During the onset of the Covid pandemic (the first quarter of 2020) equity markets fell meaningfully. In contrast, many investors who incorporated all the steps above into their approach only saw portfolios fall by a relatively modest amount.

This meant that investors needing to draw down from their portfolio to meet spending requirements and outgo, a concern for many during the Covid pandemic (much like the current environment), could do so from a relatively stable base.

Pulling the levers above may sound daunting, but the industry is evolving, and it is now possible for charities of all sizes to access sophisticated portfolios that historically were only available to the largest investors, whilst also delivering value for money in terms of fees.