Investment issues

PHILIPPE BOLOPION, managing director of asset management firm TOBAM, says why charities investing in stocks directly or indirectly connected with autocratic governments is not a good idea in terms of investment results, and that investing in democracy makes better sense.

The trustees of charities overseeing endowments often find themselves somewhere in a state of thinking between two extremes. Those who believe that their number one mission is to provide the highest possible investment returns at any cost, principles be damned. And those who believe that the charity’s investments should be the perfectly virtuous embodiment of the organisation’s mission and values, profitability be damned.

Both sides have a point. For many charities competing in a crowded fundraising field, the endowment is one of the few reliable and predictable sources of income. It’s the bloodstream of a charity, empowering it to do good in the world. Smaller returns equal less impact. With this approach, constraining the investment strategy in the name of ill-defined ethical principles is bound to generate inferior returns, resulting in a self-defeating strategy.

The other side will see it very differently. Money talks, they will say. If an environmental charity is heavily invested in fossil fuels, what good does it really do? If a human rights charity is heavily invested in Chinese and Russian companies propping up autocrats, is it really having any impact? With this approach, aligning the charity’s investments with its values is not only prudent from a reputational standpoint, it’s also an ethical obligation and a mission-driven imperative well-worth the cost of inferior returns.

In the real world, most charities will settle somewhere in between, screening out investments that would be too obviously at odds with their mission, without going out of their way to design the most ethical portfolios, whatever that means to them.

But the premise of this debate is that charities face a necessary tradeoff. That “doing good” is coming at the cost of “doing well”. Is it? Not necessarily.

Asset managers are rarely experts in ethics. They face a complicated world where information is spotty, transparency is in short supply, science is debated, supply chains are interconnected and terms like ESG are politically supercharged (“woke capitalism” anyone?). Their role is not to decide for their charity clients what is good for the world and what is not, what is principled and what isn’t. In other words, asset managers should not indulge in philanthropy with their clients’ money.

What they should be able to discern, though, is what creates long-term value for investors. What works, versus what doesn’t work.

Superior economic returns

There is a lot of academic research suggesting that democracy, as a form of government, delivers superior economic returns. A giant in this field is Daron Acemoglu, a researcher at MIT who has famously shown that when countries go down the path of democratisation, it raises their GDP per capita, while countries which revert to autocracy see their GDP per capita deteriorate.

The reasons explaining this phenomenon are intuitive. Democratic countries are far from perfect, but they guarantee checks on executive power. Journalists, opposition parties, civil society activists and ultimately electors can expose, sanction and remove a leader who makes irrational, corrupt or incompetent decisions. The system is built to self-correct and offer avenues for recourse.

An autocrat, on the other hand, will often make decisions that serve them or their clan and ensure their survival in power, whether or not it benefits the country’s population or the economy. Checks on the autocrat’s power are weak and flimsy. In this form of government, independent journalists are jailed, civil society advocates silenced, demonstrators hunted down and political opponents persecuted or poisoned.

It’s quite clear that autocracy is bad for business. But how are charities and their investments exposed to the vagaries of distant authoritarian countries? In two major ways.

First, directly, through the bonds and stocks they own which are listed in autocratic countries. If they own Chinese tech stocks, they may take a hit when Xi Jinping decides that he needs to crackdown on the entire tech sector or when Jack Ma of Alibaba disappears for a few months, sending the stock into a tailspin.

Heavily reliant

Second, charities may be exposed through the stocks they own which are listed in democratic countries but which are heavily reliant on autocratic countries. Think Volkswagen and its factory in China’s Xinjiang region. This indirect exposure became painfully clear when Russia invaded Ukraine and for example BP wrote off $25.5 billion on its holding in Rosneft or Société Générale took a $3.3 billion hit through its stake in Rosbank.

Through quantitative research, it is in fact possible to demonstrate that, buried deep in market data, there is an “authoritarian risk factor” that can be identified. This risk factor, largely ignored by the market, is negatively rewarded over time and is independent from other risk factors.

Crucially, most of the exposure to this risk factor is indirect (Russia scenario), meaning that even if a charity’s endowment decides to sell all of its Chinese stock, it will still be exposed to the irrational decisions of the Chinese government through stocks listed in democratic countries but which are heavily reliant on China.

Once you can identify and measure an “authoritarian risk factor”, it’s possible to build public equity portfolios that are minimally exposed to this risk. Using publicly available data, you can blacklist stocks listed in autocratic countries and minimise your exposure to stocks which are listed in democracies but dependent on autocracies.

HOW DO THE RESULTING PORTFOLIOS PERFORM? Here lies the good news. Using data over the last fifteen years, you can demonstrate that these portfolios outperform their benchmarks significantly and can help mitigate geopolitical shocks caused by authoritarian countries. In other words, your portfolio can perform very well.

BUT DO YOU DO GOOD? Few people realiSe it, but democracy is under attack globally. The most reputable observers of democracy, whether it’s the Economist Intelligence Unit, Freedom House or the V-Dem institute, all agree that for close to two decades, democracy has been receding in the world. It’s a declining form of government. China and Russia are much less free today that they were twenty years ago, so is India, but democracy has also been receding in the US and several European countries.

This presents an existential threat that few charities can afford to ignore, as it will often profoundly impact their mission.

Stanford Professor Larry Diamond calls the phenomenon a “democratic recession”. According to historian Anne Applebaum, the trend has been precipitated by a club of rogue state actors she calls “Autocracy Inc”, made up of Russia, China, Iran, Venezuela, and the likes. Their corrupt state-owned enterprises do business with one-another and they work together to undermine democracy globally while evading western sanctions.

Unwittingly bankrolling autocrats

In his recently published book (“Beyond the ESG portfolio, how Wall Street can help democracies survive”), economist Marcos Buscaglia argues that western investors have been unwittingly bankrolling autocrats who are hell bent on destroying democracy. They gleefully invested in Russia even after the invasion of Crimea, long before Ukraine, and poured money with abandon into China while Xi was making clear that he would settle for no less than absolute power.

In many of the “Autocracy Inc.” countries, even theoretically private companies are tightly controlled by the state. It is notorious, for example, that the Chinese Communist Party is deeply embedded in multinational Chinese companies or that Vladimir Putin keeps an iron grip on the most dominant Russian companies.

When these companies do well, so do the rulers and their oligarchs. Money being fungible (interchangeable with other assets), any profit they generate for the state can help fund military adventures, finance the control of their own population or pay for propaganda campaigns meant to destabilise democracies. There is a growing body of evidence showing that Moscow and Beijing have been trying to influence elections in the West.

Charities invested in autocratic countries face a lose/lose scenario by which they decrease their risk-adjusted returns, therefore limiting the ability to support their mission. Only the autocrats win at this game.

Buscaglia is urging the ESG ecosystem to add a “D” for democracy. And he is right. If investors in democratic countries shy away from investing in autocratic countries, it will be much harder for dictators to attract the capital they need to consolidate their power at home and undermine democracy abroad.

Comply with laws

Also there is an added benefit to investing in democracy. When a charity’s endowment invests in the shares of a company listed in a democratic country and doing most of their business with other democratic countries, it knows that these companies have to comply with laws that better protect workers, shareholders, consumers and the public.

It’s not a guarantee that these companies will be virtuous, but they will be regulated by governments and legislators answering to voters. They can be taken to court or exposed by the media for polluting the environment or mistreating their workers. Not so much in Russia. It’s much harder getting away with the use of forced labour in Sweden than it is in China.

While not a panacea, at a portfolio level, and in the aggregate, investing in democracy in this fashion can be a way to cut through some of the ESG noise and feel confident that the money of a charity donor in London does not end up subsidising a campaign of mass atrocities in Xinjiang or war crimes in Ukraine. All the while generating superior returns.

In the end, by investing in democracy, doing good is what helps your charity do well.

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.