Charity investors need to address certain investment issues. The articles accessible via the headline links below help you make the right choices in your circumstances.

Click on the headlines of your choice.

How best to review your charity's investment performance

Ongoing legislation affecting UK charities has brought the focus of many trustees onto the way their investments are managed. The Charity Commission's document "Charities and investment matters: a guide for trustees" (known as CC14) has highlighted the requirement for trustees to review their investments to ensure that performance is acceptable over time.

Where an external investment manager has been appointed, additionally the investment manager should be placed under scrutiny and trustees must be extra vigilant to ensure that charity funds are not diminished by poor management.

In seeking to review investment performance, many charity trustees may feel that they do not have the relevant information, investment insight and expertise to judge portfolio performance. Indeed, assessing performance is not a simple task! It is not just a question of looking backwards at return numbers but understanding the risks being taken to generate those returns.

More in-depth analysis can reveal risks that can be mitigated before they lead to performance disappointment. Factors such as liquidity, transparency of pricing and complexity are just three examples of risks that trustees might wish to consider in a portfolio review.

However, for the purposes of this article, let's consider three areas that charities may initially wish to focus on when conducting an investment performance review: accounting for conflicting time horizons; selecting appropriate measurement yardsticks; and adopting a robust, systematic approach to addressing any findings.

Dealing with conflicting time horizons

The investment time horizon for a portfolio is often 10 years or more; in the case of endowment funds it is theoretically infinite. However, for most charities the amount of money available for investment is not a constant. Rather it waxes and wanes according to the funding cycle of the charity. It therefore becomes important to understand how the investment portfolio is performing over much shorter periods as this has a direct influence on the scope of charitable activities being planned for the future.

In practice, performance is usually considered on at least a quarterly basis. The problem which arises as a consequence is that a long term investment objective becomes overshadowed by short term fluctuations in equity and bond markets. To avoid being carried away by sentiment swings and the latest "zeitgeist" a balancing act is needed with the trustees mindful of the long term goals but receiving regular updates and undertaking regular reviews.

A start might be to review performance on a discrete quarterly and calendar year basis, but also to review rolling one, three and five year periods. Trustees should certainly aim to give a new portfolio manager at least 36 months before being tempted by a replacement unless performance is abysmal or corporate changes, such as mergers or key staff leaving, cause concern.

Selecting a measurement yardstick

When setting the investment objectives for a portfolio, the law requires that charity trustees are satisfied that the overall level of risk being taken is appropriate for the charity given its objectives. In other words, both target risk and target return (capital and income) need to be considered and quantified. As well as forming part of an investment policy statement, these key factors are typically expressed in a "benchmark" against which future performance will be judged.

The Charity Commission suggests taking expert advice when setting benchmarks and historically a market index or composite of indices has been used. However, these can be misleading and even unhelpful as the sole measure placing portfolio performance into context.

A more robust approach is to consider using four yardsticks: cash; the manager's benchmark; "cash +X%"; and a suitable peer group. Let's look at each of these in turn.

Cash is easy to reference and currently relatively easy to beat. Many trustees take the view that if the charity investment manager is not tasked with at least beating the return of cash over time there is little point in investing at all. Cash can be thought of as a proxy for the "risk-free" rate of return.

Traditionally, investment managers have used financial market indices (such as FTSE All Share; MSCI World Equity; Citigroup World Government Bond; etc.) or composites of such indices as benchmarks against which relative performance can be measured.

Usually, the benchmark is a composite of financial market indices including equities, bonds and cash in appropriate proportions, representing the various asset classes and opportunities into which the manager can invest. The investment managers objective is then to beat this composite benchmark after costs. The main advantages of using a basket of financial indices as the basis for assessing portfolio performance are simplicity and transparency.

More recently, absolute return style mandates have become popular and managers have been moving towards "cash plus X%" measures or "inflation plus Y%" targets. Both have their merits. This type of benchmark is arguably the most appropriate one for charities which do not have a fixed life and are seeking to maintain a real level of giving each year into the future.

Absolute return style benchmarks allow the manager much more flexibility with asset allocation than the traditional index composite approach; for example, there is scope to reduce risk and preserve capital in falling markets. The objection to these as stand-alone benchmarks is that it is difficult for a trustee to quantify whether the target is challenging enough and whether the manager is adding value or being "given" the targeted return by the financial market.

Finally, there is peer group performance or "what could I have got elsewhere?" There are now peer group indices available which reflect the "opportunity set" available and provide a reference to illustrate how any investment manager is performing against the industry average.

Adopting a systematic approach

Once a series of performance yardsticks have been established, a systematic approach to assessing portfolio performance should be applied. This process needs to go beyond purely looking at returns and encompass risk and consistency amongst other factors. There is no 'silver bullet' statistic; rather any quantitative approach will need a qualitative (commonsense based) overlay.

As a starting point, trustees should consider whether returns are in line with their expectations and whether the risks that are being taken are tolerable. Is the return per unit of risk acceptable? Has the pattern of performance produced any surprises? Other considerations such as liquidity, transparency of pricing and complexity are just three factors that trustees might also wish to assess in a review.

There are a number of technical and practical difficulties in implementing a systematic, standardised approach to performance assessment including: data collection issues; treatment of fees and charges; impact of investment constraints; and how to deal with strategic holdings amongst others. However, without a systematic process, evidence of an audit trail becomes much harder to maintain and making a decision to change a manager becomes a more qualitative judgment.

In addition, by adopting and rigorously following a systematic procedure including a robust escalation process when questions or problems have arisen, the visceral aspects of manager change are ruled by evidence rather than emotion.

Make time to discuss investments

In practice, trustees should consider using a range of measures to ensure their investment policy is appropriate, reflecting the relevant time horizon of the charity and, crucially, the interaction of fundraising with grant giving over time. Assessment of any external investment manager should be multi-faceted and include more than just comparing returns versus a traditional index-based benchmark.

This is not always straightforward. Trustees may only meet twice a year so it is incumbent on the investment manager to assist trustees through regular and timely reporting. Detailed and regular communications remain the key to success. Some charities tackle this challenge by having separate finance or investment committees enabling them to monitor their investments more regularly and in-depth. Others appoint independent investment advisers to hold the investment managers to account.

Monitoring investments to ensure that charity assets are not mismanaged and establishing robust and objective methods of assessing manager performance, given the increased legal requirements, must be treated with the seriousness and attention to detail that it requires.

ARC's Lynn Pates - assessment of any external investment manager should be multi-faceted and include more than just comparing returns versus a traditional index-based benchmark.
"It...becomes important to understand how the investment portfolio is performing over much shorter periods as this has a direct influence on the scope of charitable activities."
"As a starting point, trustees should consider whether returns are in line with their expectations and whether the risks that are being taken are tolerable."

Defining a sustainable investment approach

Public awareness and interest in sustainable investing has grown significantly in recent years, a trend that has been reflected in the charity sector. This growth in popularity has been accompanied by a shift in the understanding of the concept and its place in the investment process.

Trustees increasingly want to know how the returns on their invested capital are being generated, the extent to which non-financial risks are being incorporated, and if it is possible to both "do well" and "do good". As a result, sustainability is, or at least should be considered as an integral part of the due diligence process behind any charity's investment portfolio.

The terms

"Sustainability" is an often opaque principle with subjective definitions, both for individual investors and institutions like charities. It has evolved beyond just so-called green investments and ethical funds to encapsulate a more fundamental approach to investing.

In broad terms, we could think of a sustainability spectrum ranging from an unconstrained approach to investing at one end - focusing on financial returns regardless of where the assets are invested, to philanthropy at the other, where all assets are donated towards good causes with no expectation of financial returns.

Within the boundaries of these extremes are various terms that look to capture a range of investment approaches. The most long-standing are terms like "ethical investing", which expresses a subjective preference about what assets a portfolio should not contain, and socially responsible investing (SRI), a subset of ethical investing that aims to constrain the investment universe in an attempt to avoid social harm. The way that both of these terms are implemented is inevitably subjective and personal.

However, sustainable investing today can be guided more by measureable rather than emotional principles. Investment is about knowing the risks that you as an investor are exposed to, accepting those risks, and assessing whether you are being rewarded for taking those risks.

Another commonly used term in this field, ESG or environmental, social and governance factors, include a full range of non-financial risks that should be considered in the portfolio construction process. These factors remain valid regardless of any emotional biases, and ignoring them may pose a threat to the achievement of investment objectives.

Simplistically, if there are two identical car manufacturers which could potentially be included within a portfolio, one which is actively addressing carbon emissions concerns and another which is not, an equity analyst is likely to, all other factors being equal, consider the former as a better long term investment since the management is actively dealing with this long term risk factor.

Catalysts for change

A range of factors have contributed to the rising popularity of sustainable investing, including government incentivisation, whether through emissions targets or the promotion of social impact investing, as well as an increased awareness of the negative long term consequences of persisting with the status quo. A recent example is a report from the UN International Panel on Climate Change.

In addition, there is greater public awareness and heightened social consciousness around these issues. Arguably, there is a greater desire to invest with purpose and effect positive change, especially amongst younger generations.

Investment horizons are also an important factor. Charities in particular share a long-term investment mentality to ensure that they can continue to contribute to society for as long as possible, and this is also helping to bring sustainability factors to the fore.

Know where you stand

For charity trustees, the tension between the search for returns and the desire to be "ethical" or "sustainable", however they choose to define the term so as not to contradict the underlying values of the charity, can raise significant debate.

Fundamentally, trustees need to have a solid grasp of the different principles, know where they sit on the sustainability spectrum and how this should be reflected in their investment policy. Once in place, trustees may decide to put their mandate out to tender and choose a suitable investment manager (or managers) which can effectively translate the objectives of the policy into an appropriate portfolio construction.

This selection process can be a daunting task, but it is an important one in order to ensure that the charity's investment objectives are met. Most emphasis is commonly placed on the price and performance of the prospective investment managers, given that these are most easily quantifiable.

However, an objective process of selection should also include an assessment of how the manager will invest the charity's assets in line with the outlined ethos and values, and in a way that is sustainable over the long term.

In a situation where the trustees lack the expertise to formulate an appropriate investment policy to start with, some investment managers will be able to provide advice on how objectives can be articulated and implemented. In addition, there are industry guidelines to bear in mind.

For instance, there have been recent changes to the Charity Commission's guidance that have opened up greater opportunities for trustees to implement mission related investment and accommodate a lower rate of return, so long as the strategy reflects the charity's values and ethos, and is justifiably in the charity's best interest.

Portfolio implementation

Many of the perceived shortfalls of sustainable investment are linked to the "traditional" definitions of ethical investing and the highly subjective way that one's core views are implemented. Crucially, the debate about the sub-par level of returns achieved by investing "ethically" can only be based on a series of assumptions deemed valid by the individual investor/fund manager.

In reality, sustainable investment in the modern context is more like an additional lens in an investment manager's due diligence process. In many cases, the conversation has moved beyond simply screening for so-called "sin stocks" and actively ensuring that the research process takes into account the full range of risks that each underlying asset will be exposed to both in the short and long term.

Detangling the language

Detangling the sometimes confusing language and clearly establishing a succinct approach is especially relevant for charity trustees, who are typically focused on generating a financial return without breaching the charity's aims or constitution.

The issue of sustainable investment is by no means a static concept and it is a way of thinking that will most likely become mainstream. Endowed charities and their trustees have the opportunity to significantly affect the way these principles become embedded in investment processes and products in the future.

RBC's George King (left) and Nick Reid - trustees need to have a solid grasp of the different principles, know where they sit on the sustainability spectrum and how this should be reflected in their investment policy.
"...sustainable investing today can be guided more by measurable rather than emotional principles."
"...there is a greater desire to invest with purpose and effect positive change, especially amongst younger generations."
"In reality, sustainable investment in the modern context is more like an additional lens in an investment manager's due diligence process."

Having confidence in your investment manager

After the recovery in markets since the credit crisis in 2008, charities might be forgiven for feeling calmer now that their investment portfolios have probably risen in value and are generating good income. Nevertheless, stressful or unexpected events often cause charities to give more focus to their third party relationships. Investment managers may have also revised their investment processes in light of changing economic conditions and hopefully have improved their relationships with the charities they look after.

Managing client expectations with transparency and honesty, offering good customer service - these generally maintain goodwill during volatile times. However, when the going gets rough, are trustees really prepared to hold their nerve and stick with their manager if the roof falls in, and if so, for how long?

On the whole, charities are a forgiving lot. After all, they are benevolent by nature and forgiving of others difficulties. This is acceptable to a point, but when they are paying for a service from a professional organisation, being charitable doesn't apply. The trustees' dilemma is that they have a duty of care to maximise the returns of the charity within a given level of risk, while at the same time ensuring the assets that they entrust to an investment manager are secure and properly looked after.

Monitoring the investments

Trustees need to monitor the investments and the manager to ensure that both are performing in line with stated expectations. On a periodic basis, charities should review the broader range of investment managers as part of their duty. This should address changes to investment styles available or the financial circumstances of the charity, and to ensure that the charity is getting best value for money.

As anyone who has been through the process of appointing an investment manager will know, it is a laborious process if done correctly. Trustees should first identify what they want to achieve from their investments and articulate this in an Investment Policy Statement. They should consider any restrictions, needs for current income, any ethical or social investment.

They should also consider the level of service from their prospective investment manager. This could range from a fully discretionary relationship where the manager offers investment advice and has the power to invest within agreed guidelines, through to an advisory service where the investment manager acts on the instructions of the trustee. A charity also has the option to make its own investments by directly purchasing investment funds, such as a Common Investment Fund.

The general rule is that if trustees do not have someone on their board or within the charity who has investment expertise, they should obtain independent advice and outsource the investments to an organisation that is regulated to carry out this function. An increasing number of charities have someone with investment experience on their board, or co-opted in to offer assistance on asset management on a pro-bono basis. This is useful as it could save the charity time and money in gaining investment advice and market developments, provided they are independent of the manager.

So what should be done if an investment manager consistently underperforms or fails to uphold the service to the charity that was understood and agreed at the outset? Usually a clear and frank discussion with the incumbent manager at a regular review meeting should address any issues.

Analysis of underperformance

Analysis of why their investments are underperforming a pre-agreed benchmark should take place. Is it the investment philosophy of the manager that is out of favour? This was the case in the late 1990s when high growth technology shares were very popular during the infamous dotcom boom. If your investment manager was investing in undervalued stocks, it was likely that they missed out on the boom in technology companies whose shares were very highly valued.

This issue continued for a number of years until the tech bubble burst in March 2000. Such investment bubbles have occurred a number of times over time, from the Dutch Tulip bubble in the 1630s, the South Sea bubble of 1711 in the UK, through to the Wall Street crash in 1929 and finally the real estate bubble in the US that led to the credit crisis in 2008.

The instinct of a charity at this stage is to sell or sack the manager at the point of panic or a period of underperformance and reinvest with those who have recently done well. Ironically, this is usually the wrong time to jump ship as often managers, investment styles or certain assets, like smaller companies or commodities, outperform their peers following a period of weakness. This is largely due to the cyclical nature of economies and investment markets.

Charities which are making a commitment to financial investment, by default taking risk with the capital value of their assets, should give themselves and their manager a reasonable period of time to achieve their aspirations. There is no given time period, but it is normal to expect a full economic cycle for the reasons previously given. Provided the investment objectives are clearly articulated at the outset, the expectations should be understood by both parties. Periodic statements about the investment, meetings with trustees and regular market updates will assist with this.

Other underlying issues

Performance is only one dimension of a charity's investment manager review. The question should always be, what is causing the underperformance and what is the manager doing to resolve it? The answers often lead to other issues affecting the firm or management of the investments. The following factors will typically affect the overall relationship and should be watched out for by charities:

  • The change of ownership of the investment manager.
  • A change or turnover of staff.
  • A change in investment style or taking undue risks with investments to improve performance.
  • A change of emphasis towards charity business or downgrade of service.
  • Any fines for misconduct from the regulator.

Any of these issues should prompt a charity to raise a red flag, with the manager being put on watch for usually six to twelve months. These changes are not normally conducted in accordance with the best interests of the manager's charity clients, but in many cases, a significant change may not have a detrimental impact on the charity in the short term.

There has been a considerable amount of change in the charity investment management sector over recent years with firms merging or being sold, key people moving jobs and certain firms all but withdrawing from offering charities investment advice or discretionary services. The latter has largely occurred as a result of changes in regulation as part of the Retail Distribution Review in 2013, which dictates how investment firms must treat retail customers - as most charities are classified.

There is now a higher burden of responsibility on regulated firms to treat their clients fairly and ensure they have advised them suitably. This means they must have carried out sufficient due diligence on the charity's requirement for risk and return. While these changes have been brought about to prevent customer dissatisfaction, financial failure and fraud, a number of larger firms have withdrawn from offering investment advice to all but a few very large charities.

Taking all these issues into consideration, it is important to monitor the investment manager on a continuous basis. Unless the charity has expertise on board, it is not easy to spot changes or developments especially when trustees may have more pressing financial issues to deal with. If appropriate, it is sometimes wise to establish an investment sub-committee which may have delegated powers to give the investments of the charity a proper review. Alternatively, it may be worth employing an investment consultant to offer independent advice about the charity investment market, which might lead to a full review.

Whatever the circumstances, trustees must from time to time review the investments as part of their duty of care. This might not result in a change in the manager, but it is good governance to meet the investment manager annually to review the suitability of investment as the circumstances of the charity or manager can change. A formal review of the manger in relation to other investments available to the charity should be undertaken every three to five years. While there are a number of established charity investment management firms which are well known in the sector, trustees should cast their net wider and look at different managers offering a fresh approach.

Change of investments

It has to be appreciated that the time, cost and effort to change investment managers can be quite significant. All trustees are under considerable regulatory pressure to ensure they have sufficient information about the manager's capability to offer suitable advice, not to mention the usual security checks. Notwithstanding the issues raised in this article, ongoing reviews of investment are very important but a change of investments should only take place if there has been either a significant change of circumstances, the investments or manager are not meeting expectations, or there is a better alternative that meets the needs of the charity.

Heartwood's Guy Davies - whatever the circumstances, trustees must from time to time review the investments as part of their duty of care.
"The general rule is that if trustees do not have someone on their board or within the charity who has investment expertise, they should obtain independent advice and outsource the investments to an organisation that is regulated to carry out this function."
"Charities which are making a commitment to financial investment, by default taking risk with the capital value of their assets, should give themselves and their manager a reasonable period of time to achieve their aspirations."

Rising risks in the hunt for investment income

Most charities need all the income they can get and high income generation is often prominent on the list of investment requirements. However, against a backdrop of sustained minimal interest rates, investments generally offer much lower income returns than in the past. Charities must, therefore, either accept the drop in income or seek alternative and potentially riskier investments to satisfy the same levels of spending.

Various yield enhancing strategies have been used by charities since 2008, but at such a late stage in the interest rate cycle, a continued focus on income leaves portfolios in significant danger of capital deterioration. A total return approach to income generation can mitigate some of these risks, resulting in more reliable performance and a portfolio fit to last for generations.

There are ways to boost income, but charities should pursue them with caution . Over the past five years, three yield enhancing investment strategies have taken centre stage: extending the duration of bond portfolios, tilting bond holdings towards high yield, and shifting equity holdings towards dividend paying stocks.

Long term bonds

The first move charity investors often make when seeking to increase their portfolio's yield is to raise the allocation to investment grade bonds of a longer maturity (and consequently to those with a higher duration, or sensitivity to changes in interest rates). To illustrate, although money markets yield between 0.5% and 1%, 5-year gilts yield 1.7% (duration of 4.7 years) and 10-year gilts yield 2.4% (duration of 8.8 years). It is therefore easy to see why charity investors may try to increase their yields by investing in longer term securities.

However, there are two main risks associated with this strategy. Although long term bonds generally pay higher yields than short term bonds, for a given rise in interest rates, they tend to fall much more sharply in price. For example, when the Federal Reserve surprised markets with an unanticipated increase in interest rates in 1994, it resulted in a stampede out of long term bonds and significant losses for investors.

Secondly, current yields are so low that they provide little cushion for rising interest rates, representing a magnified risk for charity investors at today's levels. The current yield may not offset even a marginal decline in prices due to rising interest rates. Consequently, duration extension might not be such a suitable strategy for charities where principal security is important.

High yield bonds

Many charity investors also turn to higher yielding bonds, which are often exposed to significant credit risk. The bonds that are sold by companies with fragile balance sheets and a higher probability of default have become one of the most popular securities among global investors in search of income. Lured by higher returns and a low current default rate, investors have queued to buy record amounts of high yield bonds ("junk bonds"), which in turn have been sold at ever more expensive levels and often with looser protections for the lenders than equivalent issues in previous years.

There are three primary concerns. First, replacing existing fixed income with higher yield bonds tends to increase volatility by some margin, resulting in a closer correlation to equity markets. Despite a favourable short term record, since the beginning of 1999 high yield bonds have witnessed an annualised price standard deviation of 9.8% versus 6.6% for their investment grade equivalents. In addition, they have seen a maximum drawdown from peak to trough of -33.3%, versus -15.0% for the investment grade market. Where investment grade bonds can provide an important element of diversification at times of market stress, their high yield cousins fall short.

Secondly, yields on high yield bonds have reached levels that no longer compensate investors for the higher risks associated with them. The average high yield bond currently yields about 5.3%, only marginally higher than the all-time low. During the financial crisis, yields reached upwards of 20%; since bond prices and yields move in opposite directions, investing in high yield bonds now is very likely to result in capital depreciation at some point in the future.

Finally, despite anaemic global economic growth, the default rate on high yield bonds is close to an all-time low of 2.1%. Companies around the developed world have taken a golden opportunity to issue bonds at record low interest rates, and this has resulted in a plethora of new bond issues of lower quality than previously. Combined with the prospect of rising interest rates, there is clearly capacity for default rates to rise towards their long term average of roughly 5%, spelling trouble for investors in the asset class.

Dividend paying stocks

Dividend investing is more popular than ever as towering equity valuations, amid sluggish economic growth, cap the potential for further share price gains while low bond yields limit the attraction of fixed income assets.

However, portfolios of dividend focused equities commonly display a significant bias towards value stocks (i.e. stocks tending to trade at a lower price than expected relative to their fundamentals); charities are likely to suffer by opening themselves only to businesses which have low (or no) growth potential. The result is a systematic lack of exposure to important sectors that will help their portfolio to grow, such as technology and financial stocks, and an over-reliance on those which won't, namely consumer staples.

Another closely related problem is that following the dividend cuts of 2009 and 2010, the number of companies in the UK which pay dividends has become increasingly concentrated. The components of the FTSE 100 Index produce around 90% of the UK's total dividends. Relying on dividend payers therefore makes it difficult for charities to diversify their portfolios as much as they should.

Inherent concentration also leaves charity investors open to a more serious problem. If an investor buys a high dividend stock and the dividend is cut, he will suffer the double loss of income and a falling stock price. For example, in early 2010 BP was the biggest dividend payer in the UK. The Gulf of Mexico disaster saw the oil giant's profits fall dramatically and £5.4bn in dividends were cancelled. Investors were forced to take a dramatic hit to their income levels while simultaneously stomaching a crash in the capital value of their stock; the equity fell by almost 50% in just over two months.

Finally, it is important to note that the significant focus on dividend stocks since 2002 has driven relative valuations (based on price/earnings) well above their average. Appetite has been particularly abundant in 2014. To illustrate, for the year to date the S&P 500 Index posted a total return of 9.9% and it has been the highest yielding names which have driven these returns. Stocks yielding more than 6% have risen 28.9%, whereas those yielding 3% or under have risen by only 8.2%. Higher profits are needed to justify current equity valuations but given the questionable outlook for the global economy, this is far from certain.

A total return approach

As we have seen, some charities find that their need for a certain level of income has prevented them from spreading their investments over a sufficiently diverse range of asset classes. In some cases, charities may have found that current beneficiaries were at a disadvantage at times when, in the prevailing investment climate, income yields were low, even though capital growth remained healthy.

It is perhaps with this scenario in mind that the Charity Commission introduced the Trusts (Capital and Income) Act 2013, to allow all charities, including those which are permanently endowed, to take a total return approach to investing without seeking prior approval. It does not automatically force investment into low yielding assets, instead providing trustees with the flexibility to invest in them if they so wish.

A total return approach allows charities to invest more widely, and increased diversification can be a powerful strategy in managing volatility. In an environment where yields on some of the safest assets such as cash and fixed income have been supressed to historic lows, it is important not to disregard asset classes which deliver most of their return in the form of capital growth, such as many alternative asset classes (commodities, hedge funds) and index-linked gilts. Crucially, as the market sell-off in the second half of 2011 amply illustrated, such securities can provide valuable stability when equities (including dividend paying stocks) and high yield bonds are plummeting.

Whilst aligning the withdrawal rate for a charity's funding purposes with total portfolio yield makes sense on paper, in practice a charity's investment returns can suffer as a strict focus on the bottom line quarterly dividend often results in reduced long term capital growth. On the other hand, total return enables foundations to spend more on grants than would otherwise be possible. For example, The Nuffield Foundation has used a total return approach since the 1980s and spends 5% of it a year when its "actual income" is only 2%.

However, this isn't to say that total return investors favour freely tapping capital until it's gone. Rather, the goal of a total return strategy is to grow the overall money by maintaining a diversified pool of investments - some income producing, some which will appreciate in price and some which will do both. Income generation should be a goal for every investor; it is, after all, one of two key components of the total return equation. Importantly, blending the two approaches allows charity investors to benefit from the stability that income producing securities bring without sacrificing diversification or chasing securities which, in hindsight, turn out to be yield traps (because the dividends are cut).

A total return approach is not just about spending resources which under the standard rules would be capital gains. It can also be about retaining resources as unapplied total return for the protection of the interests of future beneficiaries. It may seem counter-intuitive, but in this way, investing for total return can result in a steadier withdrawal programme than if relying solely on income.Done in the right way, total return can achieve higher returns with lower risk, providing charities with the income they need today and, more importantly, the income required for future activity.

How it works

In practical terms, the following would happen:

  • The charity would select a sustainable withdrawal rate, say, 4% per annum.
  • It would make a top level allocation of 40% to high quality bonds and the balance to a portfolio of diversified global equities.
  • Cash for distributions can be generated as the situation requires, harvesting gains from equities in good times and bonds during equities' bad times.
  • Rebalancing along the way will enhance performance over the long term by enforcing a discipline of selling high and buying low.
GAM's Amy Browne - a total return approach allows charities to invest more widely, and increased diversification can be a powerful strategy in managing volatility.
"...yields on high yield bonds have reached levels that no longer compensate investors for the higher risks associated with them."
"...the goal of a total return strategy is to grow the overall money by maintaining a diversified pool of investments..."

Planning for potential charity investment disaster

Looking around the world as seen through the lens of a news camera, we could be forgiven for being particularly pessimistic about life. The horrendous situation in Gaza, ongoing battles in Syria and Iraq, the awful downing of flight MH370 in the Ukraine amongst other disasters, reminds me of the line from W. Somerset Maugham's The Summing Up, "we live in uncertain times and our all may yet be taken from us".

Maugham was summing up his position as a humble writer in comparison to the extravagance of the wealthy, but the words could equally be attributed to the uncertain world in which we live. We tend to have short memories, but those who have lived through significant strife never forget the horrors they have experienced. As we commemorate the beginning of the First World War, the war to end all wars, it is worth reflecting that we have experienced considerable stress during the last hundred years.

Relating the geopolitical issues to investment markets, charities are like all other investors. They need to be aware of all risks and shocks that could affect their wealth. No trustee wants all to be taken away from their charity and they have a duty to preserve the assets that are entrusted to them.

Given the backdrop to the world today, should we be preparing for a collapse in markets or a prolonged bear market? After a very good year for investment returns in 2013, this year appears to have sobered up to headwinds that exist and broad markets have struggled to achieve positive total returns for the year to date.

Momentum building

Of course, this is only one side of the story. Momentum is certainly building in the US, which is the engine room of the global economy. Data out of the UK had almost unanimously been positive of late. Elsewhere, China has shown signs of stabilising and in Europe the president of the European Central Bank has committed to encouraging growth with uber-dovish policy announcements in July.

Looking at the world in another dimension, one of the increasingly popular studies since the credit crisis in 2008 has been behavioural finance. This looks at the cognitive and psychological effects on the economic decisions of investors, both institutions and individuals. The related field of behavioural economics studies how markets behave in different conditions, with investor behaviour leading to bubbles and crashes.

The various academic studies point to under and overreactions to events because of investor pessimism or overconfidence. Loss aversion is another factor and it is no surprise that most investment suitability checks which managers now insist on giving prospective charity clients do place a high degree of emphasis on trustees capacity to lose capital or not.

In light of these issues, I am reminded of a trustee meeting with a Roman Catholic order and the comments of a wise old priest. In the face of a rumoured market meltdown, we discussed selling investments and holding cash. The priest summed up saying that the Church had been in existence for over 2,000 years, it had experienced many disasters without panicking and will likely be around for a further millennium or more!

It is appreciated that not all charities may be blessed with the same heritage or circumstances. While mere mortal trustees can overreact to the short term noise in the markets, most charities exist in perpetuity and can take a very long term view.

There has always been a potential mismatch between a charity and those who govern it. Unless the intention is to spend out the capital in a set period, charities tend to exist over many generations and can accept risk to get a better return for future beneficiaries. Notwithstanding the trustee’s duty of care, they are likely to be on board for a limited period of time. There can be disparity of expectation between the institution and the trustees who are loath to allow any drop in capital while they are "on watch".

In simple terms, charities can afford to take higher investment risk to meet their long term objectives providing they have short term liquidity or income to match current beneficiaries or shortfalls as a result of economic or other disasters.

Appreciating risks

Therefore trustees should appreciate the risks that exist in the world and how this might affect their investments. They should not be drawn into taking knee-jerk decisions based on psychological behaviours. As most investors know, trying to time markets – selling at the top and buying at the bottom – rarely works and in most cases is a costly exercise.

Behavioural economics have shown that despite current geopolitical crises, the markets have a tendency to march ever higher. While valuations are currently looking stretched for most asset classes, being fully invested and riding through the storms tends to add value in the long term especially if trustees are able to compound some of the returns.

Putting this in context, despite the ongoing tension in the Middle East, Ukraine and another potential economic default in Argentina, markets have risen in the year to mid-July albeit modestly. It has paid to remain invested to date.

Should trustees be preparing for disaster? There remains a degree of uncertainty surrounding the economic outlook at present, be it as a result of ongoing geopolitical risks, opaque messaging from both US and UK central banks, the occasional weak data release out of Europe, or the potential threat of an overheating US. In spite of this, global data continues to support my central view that the recovery is both broad based and sustainable.

I also believe that policy will remain accommodative and future rate increases will be extremely gradual. The world’s largest economy is beginning to fire and this will certainly boost the global economy as a whole and, in particular, hopefully kick start a dawdling eurozone.

Potential risk

That said, with the US beginning to hit full throttle, a potential risk to the global growth outlook has become an overheating US economy. It was correct to remain broadly optimistic after the weather related weakness experienced in Q1, however the strong rebound has produced a new potential headwind, in the form of increasing inflation and the risk of policy makers spooking markets by moving too early.

At present, the short term outlook appears good, with US inflation simply moving back up to target and the Federal Reserve again declaring its commitment to dovish policy. However, trustees need to continue to monitor the situation for warning signs.

In Europe, although there has been occasional weak data release from a number of EU countries the overall picture remains positive. Mario Draghi has initiated new and supportive policies, however the feeling is that he can and will go further if required.

None of the signs that preceded the 2011 correction in Europe, such as widening credit spreads and a spike in credit default swap prices, are currently evident and trustees should therefore remain constructive on the outlook for Europe. As with the US, we need to monitor the situation closely and understand structural risks to this scenario.

The recent poor manufacturing data out of the UK is seen very much an anomaly. The overall outlook has looked positive of late and the key risk has been the question surrounding the path of interest rate increases, which thanks to the recent poor data release has most likely been pushed out to 2015.

Elsewhere, sentiment in Japan and China has improved recently, as pro-growth and reformist policies start to take effect. The hope that this time, particularly in Japan, the reforms will have lasting positive effects.

Sufficient liquidity

In summing up, there is no doubt we are living in uncertain times but the economic signals are not indicating a critical point to make dramatic changes to charity investment portfolios. By all means, trustees should be assessing the risks that are specific to their charities as part of good governance. Ensuring there is sufficient liquidity in reserve for the short term to meet current objectives is a better means of disaster planning and should balance the risk of remaining invested for a brighter future.

Heartwood's Guy Davies - there is no doubt we are living in uncertain times but the economic signals are not indicating a critical point to make dramatic changes to charity investment portfolios.
"Behavioural economics have shown that despite current geopolitical crises, the markets have a tendency to march even higher."

Investment issues being considered by charity trustees

After a strong performance in investment markets in 2013, charities are witnessing a more muted appreciation in their share portfolios in 2014 as the world digests mixed economic data from the US and China, and ongoing geo-political unrest notably in the Ukraine. Having ridden a generally positive market since the credit crisis in 2008, trustees have held their nerve and while there may have been a renewed focus on investments, there has not been a wholesale shift in attitudes towards risk and return.

One of the issues I face as a trustee of a number of charities is the ongoing appropriateness of their investment portfolios. Psychologically, my attitude to risk differs between the money I advise for charities and the small amount of investments within my own SIPP (self-invested personal pension). This may not be surprising given the different timescales for investment, but as the Trustee Act states under the General Power of Investment, “a trustee may make any kind of investment that he could make if he were absolutely entitled to the assets of the trust".

I therefore speak to others within the charity investment market and trustees who have an investment interest to gauge the current issues that are of concern.

Sometimes brief attention for investments

The reality of charity governance dictates that when trustees meet, general strategy, grant making, staffing issues, etc. are higher on their agenda. Investments are often the last item to be discussed and any difficult decisions are sometimes deferred to the next meeting.

As an investment manager, I sometimes find that trustees give a brief attention to their investments and unless there is a finance or investment subcommittee, there are a limited number of people who have sufficient interest in their funds to have a meaningful conversation in the brief time allotted to it at trustee meetings.

Conversely, certain charities are so obsessed by their investments they watch daily volatility of markets and are not afraid to berate their investment manager as soon as performance strays below expectations.

So what are the current issues that are discussed by charity trustees? They typically heighten as a result of market corrections, when the capital value of the charity’s portfolio takes a unexpected fall. Changes in the corporate structure of the investment manager, such as a merger or acquisition, will prompt trustees to consider their investments. Furthermore, if their nominated investment manager moves to a new fund management firm, it could cause a formal review.

A reduction in service, poor relative investment performance or a significant change in the charity’s finances will also provoke discussion and certainly comment. Against the background of good investment returns in recent years, I have not seen a significant increase in the formal review of investments or adverse comments about their investments by charities. This doesn’t necessarily mean that all is well, and indeed a period of status quo may be tested if current dull market returns continue for a prolonged period.

Issues which do crop up

There are a number of issues that trustees are discussing when considering their respective investments and will frequently crop up irrespective of whether they are considering an investment review.

In no particular order these are:

PERFORMANCE. this is always a subjective point as comparing past performance is not a reliable indicator of future performance. As a general rule, investments that demonstrate very strong returns in rising markets are likely to fall further than average in a downturn.

When comparing one manager against another, it is important to ensure that the underlying investments or mandate are similar in order to achieve a fair comparison. It is also important to know if the performance quoted is before or after fees have been deducted, as the cumulative effect of fees can be quite marked over a longer time period.

INVESTMENT APPROACH. There have been a number of in-vogue investment approaches designed to get better returns in varying market conditions, with varying results. The attraction of absolute returns has diminished as hedge fund returns have been anaemic at best, considering the higher fees. Target return and inflation based investing, where the investment is not necessarily linked to a particular asset class or market, still remains popular.

An extension of this is the concept of global multi-asset investing. This entails, as the term suggests, having a global investment strategy incorporating different asset classes from equity, bonds, property and other alternative assets. Whatever the process, one trend charity trustees have accepted is the greater diversification in portfolios and higher exposure to overseas markets.

STOCK PICKING VERSUS POOLED FUNDS. There are no hard and fast rules about the alternative approaches but they do polarise opinion between the traditionalists who value the ability to pick one company over another to gain extra returns and those who are happy to use a pooled fund.

A generally recognised and academically proven aspect of investment is that asset allocation - the amount you invest into shares, bonds, cash, etc. - is the most important investment decision and derives most of a portfolio’s return.

How you implement the asset allocation decision comes down to investing directly into shares or using a pooled investment, such as managed fund or a tracking fund. Costs will have an impact on this decision, but if you can find an investment manager who can outperform through good stock selection, this might be worth paying for.

COSTS NEED TO BE TAKEN INTO ACCOUNT. Care needs to be taken regarding costs as investment managers are notorious for quoting an annual management charge but perhaps not all the underlying costs borne by the charity. The concept of the Total Expense Ratio (TER), which has been superseded by the Ongoing Charges Figure (OCF) should outline all costs of the investment, including: administration, custody, client service, investment management, any underlying fund management charges, and dealing commission.

Common sense on costs

The OCF is aimed to ensure that under current regulations, investors are treated fairly. Common sense should prevail on costs and careful analysis needs to be taken to ensure whatever cost is being quoted is true and fair. If it looks expensive, make sure you are getting value for money. If it looks cheap, it normally is for a reason!

INVESTMENT ADVICE. Offering advice to trustees on the suitability of their investments or in setting an appropriate investment strategy is becoming less common. A number of larger fund management groups have pulled away from offering this service to all but the very large charities which they manage investments for. Other managers can offer advice but it is restricted to the investments that they offer.

If the charity doesn’t have a qualified trustee or co-opted investment professional advising it on a pro bono basis, it might consider employing the services of a financial adviser at an extra cost.

STABILITY AND SECURITY. It is a fairly common factor that trustees will follow a path of least resistance when making difficult choices. This is certainly the case when it comes to selecting investment managers. If you study the league table of charity investment managers over the last 10 years by assets under management, it is not surprising to see the same names crop up year after year.

Trustees will never be criticised for selecting a firm which offers safety and stability. It is however a shame that smaller investment management firms which offer different approaches and high levels of client service are not included in reviews more often. Selecting a well known brand name makes sense from a point of safety but it might not prove to be the best outcome for investment performance and ongoing service.

RISK. This comes in a number of different guises from investment volatility, security of the assets, counter-party risk, the risk that the capital value will not keep in pace with inflation or liquidity risk should a charity want funds on a short term basis. There are a number of other risks charities could consider, but poor risk management will likely cause trustees sleepless nights.

Realistic expectations about returns

A large element in managing investments is to set realistic expectations. If trustees want annual returns of 10% or more, they will have to accept a considerable amount of risk that the investments may not achieve this rate and they will have to take on high risk to get there. Problems often occur if the respective risk factors are not clearly articulated at the outset and understood, especially if the charity is delegating investment management to a third party.

INCOME. Although most charities can now invest for a total return (a mixture of capital and income), charities generally still like to receive a relative amount of distributed income, by way of share dividends, bond interest or rents on property. In recent years, we have witnessed a period of low interest rates and the hunt for safe and sustainable income has been an issue on the minds of trustees, who are looking for money to gift to their objects or fund their charity's activities while not wanting to dip into the capital.

ETHICAL/SOCIALLY RESPONSIBLE/MISSION RELATED INVESTMENT. Following the revision of the Charity Commission’s guidance on investment, CC14, the focus on more ethical investment has been heightened. It states that trustees of any charity can decide to invest ethically, even if the investment might provide a lower rate of return than an alternative investment.

While adopting an ethical investment policy may not cause an investment review, more charities than ever are considering an appropriate ethical stance and the recent investigation by the BBC Panorama programme on the investments of Comic Relief highlights how charities need to give the issue serious consideration. While the market for specific mission related investments has not developed greatly beyond Social Investment Bonds, trustees will be giving this area more attention when they review an appropriate investment policy for their charity.

LOCALITY. An interesting factor for charities outside the main financial centres is a tendency to employ a local investment manager. This might be a larger national firm, with a local office, but the advantage of having a local presence to the charity is a distinct advantage for some trustees.

Issues may start to reappear now

The recovery in markets since the credit crisis in 2008 has calmed the of minds of trustees and in the good years such as 2013, with returns averaging 15% for mixed asset charity portfolios, the issues raised above tend to subside or are deferred for a while. Investment returns for the current year are not so great at around 2%. If things continue at this pace for the foreseeable future, added to a reasonable bout of investment manager changes over the last 12 months, trustees will start to give greater attention to their investments, as they have a duty to do.

Heartwood's Guy Davies - problems often occur if the respective risk factors are not clearly articulated at the outset and understood, especially if the charity is delegating investment managers to a third party.
"When comparing one manager against another, it is important to ensure that the underlying investments or mandate are similar in order to achieve a fair comparison."
"...if you can find an investment manager who can outperform through good stock selection, this might be worth paying for."

Pooled and segregated investing for charities

Let's first consider the characteristics of pooled and segregated funds. A pooled fund gathers the assets of a number of investors in a single collective investment scheme, which is invested in accordance with a given set of objectives. The assets are held by the fund, and the investor owns shares (or units) in that fund of a value equivalent to the size of its investment.

Pooled funds are referred to by different names, the precise name depending on the legal structure of the fund and its ability to accept new entrants. All such schemes offer the benefit of diversification to investors, irrespective of the amount invested. As pooled funds combine a number of clients’ assets, a smaller investment is required to achieve diversification of assets than is the case with a segregated fund.

In a segregated fund, also known as a "separately managed account", the assets of an investor are managed separately in a distinct account. Segregated funds are tailored and adapted to particular client requirements, for example to reflect the avoidance of investment in particular sectors or stocks. A pooled fund must adhere to its objectives and defined parameters, and does not reflect any specific client preferences.

In reality, an investor’s portfolio may well combine elements of both pooled and segregated approaches. An investment manager may, for example, hold units in pooled funds for a charity which, on a direct basis, has insufficient resources to achieve appropriate diversification in particular asset classes through direct holdings.

Such asset classes might include emerging market equities, commercial property and "alternatives". A manager may hold such pooled fund interests alongside a number of direct equities and bonds. Of course, it should be emphasised that whether a charity uses a pooled or segregated approach, the value of its investments can fall as well as rise, and it may get back less than it originally invested.

Choices for charities

In determining which arrangement is in its best interests, a charity should pursue an approach that concurs with its investment objectives most effectively. In this context, it is worth noting that a growing variety of pooled funds is available to meet a broad range of charity-investor objectives, including those focused on income generation, ethical investing, and absolute-return investing.

From a diversification perspective, the level at which one might consider a segregated rather than pooled approach can be debated. Nonetheless, there may be good reasons to take one or other approach, and a pooled approach may be appropriate even for much larger investments. These reasons include the benefit of locking into an investment manager’s flagship strategies, which, in contrast with segregated funds, will tend to have investment adviser ratings and a publicly available track record.

Other important benefits include economies of scale (cost), custody charges, and ease of administration, including fewer contract notes and corporate actions, and simplified dividend payments.

On a related point, when putting new money into a portfolio, or making a capital withdrawal from it, it is easier to do so when holding a pooled fund: it simply entails buying or selling units in one transaction.

By contrast, a segregated fund investor would most probably want to sell part, or add to most, of the individual holdings in a portfolio in such circumstances, in order to preserve the structure of the portfolio. This would clearly involve multiple transactions, and, when selling, also bring the added burden of having to account for numerous realised gains and losses.

Ethical and SRI considerations

Where charities want ethical or socially responsible investing (SRI), responsible investment should be a key element of the investment manager's philosophy and process, and environmental, social and governance (ESG) issues should be thoroughly researched. All stocks on its research recommended list should be scored according to ESG factors.

I believe companies which identify and manage challenges related to corporate governance and social responsibility effectively are often stronger companies which are well placed to meet investors’ long term financial objectives.

Responsible investment should be integral to the analysis of investment opportunities. Ideally a dedicated responsible investment team should exercise voting rights, conduct research and engage with companies on ESG matters in conjunction with our other analysts. In this context, all portfolios (whether segregated or pooled) can be invested "responsibly".

Many charities have an ethical policy, and the precise nature of such policies differs from one charity to another. In general, pooled funds are less flexible in being able to meet investors’ ethical criteria than segregated funds, which can be managed to reflect the precise ethical concerns of the individual charity. However, it is possible to invest in pooled funds which have responsible and ethical investment incorporated in their objectives.

Screening for criteria

These SRI funds seek to meet the responsible and ethical investing requirements of many charities by screening the investment universe for negative and positive criteria. There are different ways of doing this, but a good approach is to exclude companies which have exposure (at a certain level) to one (or more) of the following activities: tobacco production and sale; alcohol production and sale; gambling; pornography; animal testing for non-medical purposes; abortion; armaments.

Then one can go on to exclude companies in relation to which there are significant concerns about the following: environmental issues; human rights. Also, for instance, one can also exclude companies which have broken the international code on marketing breast milk substitutes in the developing world.

Inclusions (positive criteria) can include companies which promote sustainability through: corporate governance; equal opportunities; environmental issues; human rights; community involvement; positive products and services (which could include water scarcity solutions, climate change solutions, waste solutions, environmental solutions, and safety equipment.

Other SRI considerations

EASE OF SELECTION AND MONITORING. A segregated approach allows investors to set, and maintain close control of, portfolio specifications, and to make adjustments based on changing circumstances. Segregated arrangements require a greater degree of involvement from trustees in establishing and maintaining investment guidelines.

This involvement may be welcomed by trustees who wish to keep more direct control, and who have the requisite time and experience to do so. Segregated investment management generally gives rise to a higher volume of paperwork, and to more onerous auditing requirements than pooled investing.

Pooled funds, by contrast, have their investment guidelines described in a prospectus or a trust deed, as well as in related marketing material. The depth of publicly available information about their performance and composition, as well as the typical clarity of their investment objectives, may simplify the due diligence involved in selecting a manager and initiating investment. In terms of establishing and monitoring their investment arrangements, trustees should naturally seek to ensure that the level of guidance they obtain is appropriate to their requirements.

REPORTING. It is often assumed that pooled and segregated clients receive different levels of reporting information. This should certainly not the case. There should be the same level of reporting to both pooled and segregated clients. Ideally this should consist of a comprehensive overview of fund, sector and stock performance, in addition to commentaries on the prevailing market backdrop. There is also considerable information on many investment managers' websites in the sections or zones for clients.

Investment management fees

COSTS. Fees for investment management services vary according to a number of factors, including the investment objective and the size of a portfolio. For a given size of investment, fees tend to be lower for a pooled fund investment than a segregated portfolio.

In addition, VAT is not applied to the management fees of most pooled funds, including Non-UCITS Retail Schemes (NURSs) but excluding Common Investment Funds. For segregated client accounts, fees are calculated on an individual basis. Unlike most pooled funds, management fees for segregated mandates are subject to VAT.

I believe that investment returns in the years ahead are likely to be lower (and more volatile) than those to which investors grew accustomed during the last two decades of the 20th century. Assuming this is correct, the impact of management fees and other charges on overall investment performance will be proportionately more significant.

The total expense ratio (a measure of the total cost of a fund to an investor) on a pooled fund tends to be very visible, but costs can be more opaque in relation to a segregated portfolio, notwithstanding the requirements of investment managers to ensure that, in treating their clients fairly, they are transparent about the costs of their services.

There should be transparency of all fee charges for both pooled and segregated funds. Investors should be particularly cautious about the lack of transparency and "double charging" which can characterise multi-manager arrangements, in which a notionally segregated approach (for which the investor pays a fee) entails the holding of a range of pooled funds, which levy additional fees.

Fulfilment of investors' objectives

Pooled and segregated investment approaches have some distinct features, but they also share some characteristics. Both are intended, ultimately, to enable the fulfilment of investors’ objectives.

In pursuing one method over the other, a charity should seek to ensure that its chosen approach is appropriate for the task of trying to meet its investment objectives. Insofar as the charity has an ethical investment policy, it should ensure that the solution it chooses is equipped to meet the demands of that policy.

Some charities will, by virtue of their limited resources, achieve diversification benefits via a pooled approach that they would struggle to replicate in a segregated mandate. Even for larger charities, however, pooled investing may offer an administratively simple and cost effective way to harness the flagship, adviser-rated strategies of their chosen investment manager.

Newton's Alan Goodwin - a growing variety of pooled funds is available to meet a broad range of charity investor objectives, including those focused on income generation, ethical investing, and absolute return investing.
"Many charities have an ethical policy, and the precise nature of such policies differs from one charity to another."
"A segregated approach allows investors to set, and maintain close control of, portfolio specifications, and to make adjustments based on changing circumstances."
"Pooled funds...have their investment guidelines described in a prospectus or a trust deed, as well as related marketing material."

Choosing to invest in property

Charities, like other investors, have been thinking much harder about where to allocate their money since the global financial crisis. Negative real interest rates continue to make cash unattractive and increasingly bonds look expensive. Equities have had a good run in the last few years but the volatility that goes with them can make conservative investors nervous.

It would be no surprise to charities, which by nature are quite conservative investors, to know that many surveys of institutional investors show that real assets have become more popular - and especially property.

A number of charities have been investing in property for a long time. They are attracted by the relatively high, stable income it provides, which is the ultimate goal for many charities which rely on their investments to maintain their activities. But what should those charity investors starting from scratch or which are looking to raise exposure to property know about the asset class? How do they invest and what are the benefits and pitfalls?

Attractive option

The most common type of property invested in by "institutions" can best be described as "commercial", which includes retail outlets, offices, industrial and alternative uses such as leisure, hotels etc. This is an attractive option considering the high level of total return delivered through income (70-80%), the improving economic picture and the benefit of having a real asset should inflation pay an unexpected visit.

However, it is important to choose the right parts of the market to invest in or find someone who can find them for you. So where should a charity invest? Many pension funds are switching out of corporate and government bonds which are very low yielding and are now perceived to be expensive. The interest on 10-year gilts is 2.8%, which is below inflation with RPI running at 3.2%. In effect you are losing money in real terms. Index-linked gilts are yielding 0% in real terms.

To illustrate how much more attractive property can be than government bonds, it is possible to access index-linked property investments at yields of 4% plus. A Sainsbury’s supermarket with an unexpired lease term of 28 years and annual RPI increases recently traded at a yield of 4.1 per cent. A 25-year lease to Tesco on a supermarket with annual RPI increases recently traded at a yield of 4.25%. In comparison an index linked Tesco bond trades at 0.9% per annum. So you are 335 bps (base points) better off and you also own the real estate.

Alternatively, you can go slightly higher up the risk curve and acquire a Premier Inn hotel (with a guarantee from Whitbread) for a yield of circa 6% on the basis of a 20-year lease with rental increases based on the Consumer Price Index, compounded annually but payable every five years.

Higher yields

Higher yields, sometimes up to 9% a year depending on the length of lease and quality of the asset, can often be sourced in the industrial sector of the property market, which includes manufacturing assets such as factories, and distribution such as warehouses. These investments can often be purchased at "build cost", which means 100% of the value is tied up in the real estate rather than the lease.

The manufacturing sector has benefited from the resurgence in the UK car industry over the last five years and the logistics sector has experienced strong occupier demand for space through the increased need for "just in time" deliveries and the rise of internet retailing. There has also been a lack of new construction since 2007 as developers and banks have drawn in their horns. This, combined with low obsolescence and good occupier demand, means limited empty space. Therefore this sector can provide a very high relative yield but with strong defensive qualities.

Charity investors should also think about geographic regions. London continues to outperform the rest of the UK in economic terms and this is reflected in rising prices for real estate. Population growth is projected to continue to increase and economic improvement is also being driven by regeneration (think Stratford, Kings Cross and Nine Elms) and infrastructure spending (Crossrail).

There is also value to be had in up and coming areas, such as Old Street/Shoreditch, Clerkenwell, Southbank and Vauxhall, to name a few. However, stock selection and pricing remain key to making an astute investment. An example of this would be a building acquired in Albemarle Street, Mayfair in 2006 for £1,000 per square foot, which sold in 2011 for £2,000 per square foot (100% increase).

Conversely another institution over the same time horizon acquired an office building in Milton Keynes for £12m and sold five years later for £2m – an 84% fall in value. Hence the market as a whole can mask some huge discrepancies and is certainly not a “blanket buy”. You need to be discerning.

Owning outright

Once a charity has decided it would like to invest more in property, how does it do it? One option is to invest directly. This has the benefit of owning the property outright and being in complete control. However, direct property can be illiquid due to the long sales and marketing process compared with shares and bonds, plus managing the building and deciding the best time to sell might be responsibilities that a charity may wish to delegate.

Inexperienced charity property investors might also fail to maximise performance by exploiting all the potential opportunities, such as refurbishment, redevelopment or change of use. The fall in or total absence of income when this might be happening or when a tenant goes bust is also a deterrent for some charities. If a charity is focused more on total return then this may not matter, but if it is permanently endowed it may be more problematic.

Generally, owning directly tends to appeal to larger charities because they have the scale to afford a large diversified portfolio of multiple buildings let to multiple occupiers. This means they are insulated in the event of, say a tenant default on an individual property.

A second option is to invest in a separate account. This is similar to owning property directly but the main difference is that an existing portfolio or sum of money is placed with a trusted professional adviser who builds up, or manages, a portfolio on the investor’s behalf.

This has the benefit of delegating decisions to the adviser who can then be judged on strength of performance. This should result in a better service than merely using different advisers on an ad hoc basis as investors will have teams dedicated to their portfolios. Any dissatisfaction and the investors can re-tender the management mandate after a pre-agreed period.

Simplest way

Perhaps the simplest way to invest is by using property sector shares. For example, the shares in property companies or Real Estate Investment Trusts (REITs) - such as British Land, Land Securities and Hammerson - are available on the London Stock Exchange. The downside is that these shares can be volatile in line with stock markets generally and they also tend to be low yielding. REITs also pay stamp duty so this is not a tax efficient way for a charity to access the commercial market. But they are very liquid investments.

The fourth investment option is a pooled fund. This is a fund set up with the aim of “pooling” together multiple investors to gain economies of scale and increased purchasing power. It allows access to a much larger and diversified pool of assets than can be afforded by individual investors and provides access to professional management.

Common Investment Funds (CIFs), to which charities have access and which offer tax exemptions, are a subset of pooled funds. The main benefit of a CIF is exemption from stamp duty (which is normally levied at 4% on most commercial transactions), and there is no withholding tax payable either.

Better diversification

No investment portfolio should invest in one particular asset class. As charity investors look for better diversification in their portfolios after the financial crisis they should – and are – increasingly considering property, which has matured as an asset class. Investors increasingly recognise its attractive risk-return characteristics and the benefits of holding it in a diversified portfolio.

Charities in particular should appreciate property’s ability to provide real, inflation-beating income. But they should also beware of the market’s complexities and the importance of choosing the right underlying investments.

Cordea Savill's Harry de Ferry Foster - charities in particular should appreciate property's ability to provide real, inflation-beating income.
Property in Cambridge
Owning property directly tends to appeal to larger charities because they have the scale to afford a large diversified portfolio of multiple buildings let to multiple occupiers.

Reviewing the reserves and investments of a charity

Charities which are in the fortunate position of owning long term reserves need to ensure that the assets in which the reserve is invested in are appropriately looked after. This aspect of governance is important to meet the current and future objectives of the charity. Trustees have a "duty of care" to ensure that the reserve is maintained in an appropriate manner. The purpose of this article is to highlight the key issues trustees need to consider when reviewing these assets as part of good governance.

Trustees have a "general power of investment" which ensures that charities have the power to invest the reserves in any kind of investment, subject to a number of restrictions within the Trustee Act 2000. The Act enshrines in law the powers trustees have when making investments on behalf of a charity and the need for good governance.

The governance imposed upon trustees covers a number of areas, specifically the power of investment, acquisition of land, the need to seek proper advice and the need to review any arrangements they put in place.

If we split down the key terms of the Act, it is easier for trustees to interpret what is expected from them to ensure good governance.

Reasonable in the circumstances

DUTY OF CARE. A trustee must exercise such care and skill as is reasonable in the circumstances. This means that a trustee is expected to use any particular specialist knowledge or experience they may have. Furthermore, if a trustee has specific skills in the course of their business or profession, e.g. a qualified investment manager, they will be expected to exercise a greater than normal degree of care over the charity’s assets.

GENERAL POWER OF INVESTMENT. The wording of the Act states: "a trustee may make any kind of investment that he could make if he was absolutely entitled to the assets of the trust". This replaces the Trustee Investment Act 1961 which obliged trustees to follow a very conservative investment policy.

The current broader investment powers allow trustees to invest in a wide ranging array of investment opportunities that they think are appropriate for the charity to meet its objectives. Further direction on this is given by the Charity Commission in their guidance note "Charities and investment matters: a guide for trustees (CC14)", available on the Commission’s website.

STANDARD INVESTMENT CRITERIA. Trustees need to ensure that the investments chosen for the charity are suitable, having exercised their power of investment. The Act does not define what is suitable but trustees have an overriding duty to invest in the financial interests of the beneficiaries of the charity.

There is also a need to diversify the investments as far as appropriate to reduce specific risk of investing in an asset that could detrimentally affect the value of the reserves. Furthermore, under the standard investment criteria, trustees should review the investments "from time to time".

Obtaining proper advice

ADVICE. Before exercising any power of investment under the standard investment criteria, trustees should obtain and consider proper advice. This means trustees should seek advice from someone who is reasonably believed to be qualified to give and have practical experience of financial and other matters relating to the proposed investment. The only exception to this is if trustees believe it is unnecessary to gain advice due to the nature of the investment or they have sufficient expertise within the trustee board or staff to make investment decisions themselves.

If trustees follow this process when thinking of their investments, it will enable them to set a good review structure and ensure that the governance of the assets complies with the law. If a charity is setting out to invest for the first time, possibly as a result of a large donation, a legacy, or has built up excess capital in its general reserves, trustees will need to consider a number of factors.

SHORT TERM CASH. Charities will need to consider an appropriate level of short-term cash balances to maintain their day-to-day activities such as paying wages and other overheads or pay grants. There is a need for immediate liquidity and as a result money will normally be held in cash deposits with a bank.

MEDIUM TERM RESERVES. Trustees are advised to set aside sufficient amounts to cover any unexpected significant capital payments or other costs should their short term reserves and income diminish for whatever reason. Such money will often be held on fixed term, short to medium term deposits or liquid investments such as money market funds or short term bonds.

Growing the value of reserves

LONG TERM RESERVES. These are assets that are not necessarily needed for the foreseeable future but the income and some capital could be spent on current charitable grants. Grant making charities which are not raising new funds are likely to rely on these assets and they form the endowment of the charity. Unless otherwise stated, most long term reserves that are kept for the interests of current and future beneficiaries should grow in value at least in line with the rate of inflation.

Having assessed these practical steps, trustees of charities need to decide on how best to invest the long term assets at their disposal. The first step is to draft a written investment policy statement. The Charity Commission’s guidance on investment is clear that regardless of size, having a written policy is important for all charities with investment assets.

The policy should be reviewed by trustees on an annual basis to ensure it is current in relation to the charity’s overriding objectives. Further useful information on investment policy statements are found in CC14 and the Charity Investors Group website.

As previously highlighted, charity trustees should review their investments from time to time. While there is not a prescribed interval for any review, it is customary to monitor the performance of the investments on an ongoing basis to ensure that it is meeting expectations. Common practice is to formally review the investments and any adviser to which trustees have delegated the responsibility for investing every three to five years.

This allows for normal cycles of general economic activity to have an impact and gives the investment manager a chance to statistically prove their value.

Two options for investment

By adopting the duty of care, trustees have essentially two options for investment. If they think they have sufficient expertise within the trustees or staff, they can make direct investments into an appropriate range of diversified assets. Some charities co-opt an independent qualified and experienced investment adviser to oversee investments and inform trustees. The alternative and most common route is to delegate any advice on investments to a qualified investment manager.

It is perfectly acceptable and good governance to delegate investment to a third party. This is likely to be an investment manager who would typically advise on the most appropriate investment strategy and implement the agreed approach with discretion from the trustees. This is typically done with a "two-way" agreement which clearly outlines what powers, requirements and restrictions the investment manager has been given by the charity. The agreement should complement the charity’s investment policy statement.

Selecting an appropriate investment manager can be as complex as trustees feel necessary. Once the general investment strategy has been agreed, a review of suitable investment firms could be taken by comparing the following criteria, most of which is now found on relevant websites or in the trade press:

• Corporate structure

• Regulation details

• Investment strategy

• Past performance

• Fees and costs

• Charity expertise

• Ability to provide investment advice

• Policy on responsible investment

For larger and possibly more complex investment policies, trustees may wish to issue a questionnaire to a selected number of managers to compare on a like-for-like basis. Based on the responses, it is typical to invite a short list of preferred managers to be interviewed in a competitive beauty-parade. For larger charities, in order to get good diversification, they may choose more than one manager or select particular managers to invest into different asset classes, such as one for UK shares and another for bonds or property where they have specific expertise.

Documenting all decisions

In choosing a manager, trustees must not apply any prejudices and must document all decisions made in writing. This will enable them to demonstrate that they have considered the relevant issues, taken advice if appropriate and reached a reasonable decision. The chosen manager and resulting investment must not in any way have a negative impact on the charity's donors, its overall objective, the beneficiaries or its causes.

Given the time consuming process in deciding, selecting and reviewing a charity’s investments, charities may find it helpful to have a trustee with specialist knowledge of investments on its board.

An alternative might be to establish an internal investment committee or a sub-committee comprising of trustees, co-opted experts or employees to advise the trustee board on investment aspects. Trustees should set out clear terms of reference for any sub-committee, framing their decision making and means of reporting to the board.

If charities follow this process of investing their reserves, they will hopefully take good decisions for the short and long term interests of the organisation. Governance is very important to ensure that proper controls are in place and trustees are protected from unintended consequences in their duty of care to charities.

Heartwood's Guy Davies - in choosing an investment manager, trustees must not apply any prejudices and must document all decisions made in writing.
"Before exercising any power of investment under the standard investment criteria trustees should obtain and consider proper advice."
"The Charity Commission's guidance on investment is clear that regardless of size, having a written policy is important for all charities with investment assets."
"Selecting an appropriate investment manager can be as complex as trustees feel necessary."