“Trustees are the people who exercise control over, and are legally responsible for, the management of a charity,” according to Guidance for Charities Trustees, from the Charities regulator. Therefore, all charity trustees are collectively responsible for the charity’s investments and need to understand what is happening in the organisations portfolio(s).
The current environment is providing several challenges for charity trustees, with market conditions markedly different to those prevalent in recent years. Inflation is at its highest level in more than a generation, causing central banks to pursue aggressive measures in an attempt to rein in persistently above target price increases. Other major developments this year include the Russian invasion of Ukraine, rising energy costs, supply chain constraints (ongoing Chinese Covid-19 lockdowns) and the fear of recession.
This backdrop provides a timely reminder of the importance of monitoring investments to ensure the portfolio sits within the parameters set and reflects the charity’s desired ethos – a consideration of utmost importance for charities.
State of play
From the Global Financial Crisis to the start of 2022, the expected returns from assets traditionally viewed as “low risk”, like bonds and cash, offered meagre returns. This was a result of a benign inflation backdrop and extraordinary monetary policy, with the US, UK and Eurozone all reducing benchmark interest rates to record lows and pursuing unorthodox measures, such as Quantitative Easing, which further suppressed yields.
As a result, bond yields and cash failed to offer returns that provided the required level of inflation protection and therefore trustees were forced to consider a higher exposure to real assets, such as equities and property, to maintain the real purchasing power of these reserves. This necessitated an increase in the risk profile.
Now bond markets are finally showing signs of value however, although the impact of rising rates has been keenly felt by those holding bonds prior to the turn of the year. Traditionally this has been an asset class in which charities typically allocate a relatively larger proportion of their portfolio due to perceived reduced level of risk and liquidity reasons. This has left them particularly vulnerable to the sizable declines in bond markets year-to-date. To highlight how quickly and significantly market conditions have changed, at the start of 2022 the yield on a US 10-year Treasury bond was around 1.51%, by the end of December it had more than doubled to around 3.88%.
The size of the increase has been a similar situation for core eurozone government bond yields. The German 10-year bund ended the year yielding 2.57%, over 200 basis points higher on the year, having spent recent years in negative territory. In July the European Central bank delivered its first interest rate increase in more than a decade, hiking by 50 basis points, before upping the ante and announcing a 75 basis point rise at its two subsequent meeting. The root cause of the move has been rising inflation and therefore trustees should be aware of other assets that have historically outperformed bonds during inflationary environments.
Alternatives
One such area is alternative investments, defined as an investment in any asset class excluding, equities, bonds and cash. The most popular alternative investments for trustees have been infrastructure and private equity.
It should be pointed out that these alternative investments were not been immune from the broad market declines in 2022 and, in many cases, have also suffered in the re-pricing of risk. However, they do possess certain characteristics which make their investment case in the current environment arguably more appealing.
Infrastructure can provide a natural hedge against inflation and historically has proven to offset at least some of the rising price pressure during times of high inflation.
Infrastructure investments have a reputation for providing a steady income stream and also offering a low correlation to equities – two particularly attractive characteristics in the current environment – and therefore should be on the radar of trustees.
Private equity has enjoyed impressive growth over the last 10 years and although two of the most widely cited driving factors behind this growth – near-zero interest rates and an increased appetite for risk – are no longer in place, reasons for optimism on the asset class remain. During the last hiking cycle from the Federal Reserve (2015-2019) returns were still positive and it should be pointed out that while rates have risen rapidly this year, the US hiking cycle is expected to end early this year.
Investment time horizons for private equity managers are typically longer than their traditional counterparts, allowing them to weather market volatility without the same focus on short-term markets moves which can increase the threat of redemptions.
ESG Developments
The rapid increase in awareness and application of responsible investing in recent years has meant investors are increasingly interested in whether their portfolio represents their ethos – this can be especially important for charity trustees. Environmental factors are progressively attracting a greater amount of attention, while the conflict in Ukraine has brought into sharp focus how strongly many investors feel about social factors. The outbreak of war has also shone a spotlight on some of the challenges associated with incorporating social factors into investments, raising complex and nuanced questions such as what are the social implications for investing in defence companies? Are they always “bad”? Or just “bad” if they sell weapons to the wrong people.
The impressive strides forward in the awareness and analysis of these issues have been welcome, and arguably long overdue, but they have also brought about potential pitfalls. One of the main areas of concern that has arisen is “greenwashing” – the practice whereby a company is perceived to be misrepresenting its ESG (environmental, social and governance) credentials. There has been a clear increase in demand for reporting on ESG metrics and factors, but this increased reliance on data brings its own danger and can paradoxically provide a murkier picture of the performance of a portfolio in relation to ESG factors. The absence of a global framework for data providers, means each interprets information in different ways and each will have different biases as to how they weight factors behind a score. Ratings are a static figure, a one-dimensional rating whereas considering ESG factors involves much more thought.
The proliferation of interest in ESG factors in recent years has resulted in varying degrees of competence among those claiming adherence to these principles. Effective governance is the key here and trustees should be on the lookout for clear and timely reporting along with for example, additional disclosures on your investment manager’s approach to this.
Keeping things in perspective
One of the most important concepts for trustees to remember during times of heightened market volatility, like we have seen this year, is to maintain a long-term focus and not to overreact to short-term gyrations. While it can be tempting to increase cash holdings at times like these, any benefits should be carefully considered against drawbacks – for instance several investments such as certain equities, infrastructure and private equity can offer a degree of inflation protection, whereas the value of cash, whilst tactical in the short term, is simply eroded by rising prices.
Staying invested allows you to benefit from the growth in businesses and the economy over time and successfully timing the market is notoriously difficult. In recent weeks talk of a pivot from the Federal Reserve, whereby the US central bank will end its hiking cycle, has caused sharp moves higher in equities. This speculation proved premature, and the market subsequently handed back the gains following a strong jobs report, but the speed and scale of the move higher show just how quickly things can recover following a favourable development. Many of the largest daily gains come during bear markets and trying to sidestep the downside means an increased risk of missing the recovery. As the old investing maxim states, time in the market beats timing the market.
Author
Eoin McBennett
Investment ManagerMy primary role is to build and manage bespoke portfolios for clients including Charities, Corporates, Pensions and Private Clients. By assessing a client’s investment objectives including risk, return and income requirements, I am able to establish a suitable diversified solution.