With rock-bottom interest rates here for a while, cash needs another home before infl ation eats away its value, says Richard Hyder.

Faced with a continuing struggle to generate satisfactory income from their investments, charities with cash deposits, perhaps as part of a strategic allocation to low-risk assets, are now faced with the additional challenge of negative real returns on cash deposits.

Hopes of higher interest rates were dashed recently as the Bank of England’s February inflation report gave a clear indication that record low interest rates are set to continue for the forseeable future. Rate hikes are not now expected until 2011 and even then increases are expected to be gradual. While term deposits offer higher returns, even significant deposits over 12 months might only attract rates around 2 per cent with additional restrictions on early withdrawals. While concerns over capital security have diminished, counterparty risk should always be evaluated carefully.

Another pertinent risk is that rising inflation will erode the real value of cash over time. For example, inflation of 2.5 per cent a year reduces the purchasing power of £100,000 to just £60,000 after 20 years.

For the first time since 1978 the recently published annual Barclays Capital Equity Gilt Study recorded a negative real investment return on cash. The study, which uses the returns of UK Treasury Bills as a proxy for short-term risk-free rates, recorded a real return from cash of -1.7 per cent in 2009.

In this environment there may understandably be a temptation for trustees to take more risks with their cash as they chase income or seek to maintain its real value. Where a longer investment time horizon is appropriate and capital volatility over shorter time periods is deemed to be acceptable, other asset classes should certainly be considered.

The ongoing pressure on the UK economy and public finances suggests avoidance of conventional gilts while focusing equity exposure on growth opportunities via overseas markets and through UK equities that derive their earnings predominantly from abroad. A cautious view on the gilt market has implications for corporate bonds. While supported by heavy investor flows after good recent returns, should the government be forced to pay more on its debt issuance the corporate bond market will not be immune to this threat to capital. Fixed-interest exposure, therefore, is likely to be best met through inflation-linked securities and more flexible strategic bond funds that can add returns in all market conditions. Looking elsewhere for reliable income and real returns might also take investors back towards commercial property where attractive yields should be supported in the long term by rental growth.

Charities, however, may already have exposure to these asset classes or may not be comfortable with their higher volatility. Where then should they look to enhance income levels or achieve real returns?

While many investors are understandably wary of alternative assets such as hedge funds and structured products they should not be dismissed entirely. Investment markets are endlessly innovative and alternative investment classes and structures are being developed all the time, many of which are available to charities.

Hedge funds utilise a variety of strategies and a wide range of investment tools with most having capital preservation as a primary objective. They have been proven to have a low correlation to traditional asset classes and a portfolio may therefore benefit from the added diversification. Where enhanced income is required structured products can provide further benefits. Structured products are ‘synthetic’ investment vehicles which, rather than investing in underlying securities, use financial instruments that partly replicate the performance of the asset class. They tend to have a set life, return profiles that are relatively predictable and they offer investors capital protection and/or an enhanced level of income. Increasingly many of these structured funds are UCITS III-compliant open-ended investment companies thereby removing any liquidity issues or constraints on access.

Alternative investments can be complex and trustees need to have the confidence that their investment manager understands the structure, liquidity, transparency and feeing arrangements of the investment and the nature of the risks involved. Investments should only be made after a thorough due diligence process. As an alternative to long-term cash deposits, the careful use of structured products and hedge funds alongside the more traditional asset classes should achieve added diversification, better returns and lower levels of volatility.