Identifying your own charity’s needs and investing to achieve that is key, argues James Codrington.

The last 100 years of either UK or US history have shown that investors can expect to be paid between 4 per cent and 5 per cent over the rate on a gilt or treasury bond to hold equities. But there have been several periods of considerable volatility and absolute loss, enough to discourage even the most far-sighted investors. The longest period of negative real returns for world equities was between 1901 and 1920 with a real return of -5 per cent.

The 1980s and 1990s, however, were blessed with few negative years as markets reacted favourably to supply side reforms and to the gradual reduction in inflation. Increasing correlation between assets (when both bonds and equities moved up together) seemingly rendered active asset allocation obsolete; instead, the practice of following a benchmark seemed entirely rational.

But index benchmarks such as the MSCI encouraged fund managers to put money into markets that had already outperformed – as happened in June 1999 when the US equity market accounted for 62 per cent of the MSCI World index – just before it collapsed. Also, established global equity indices tended to ignore emerging markets.

Peer group benchmarks, based on the average asset allocation of a particular set of funds, such as the WM charity peer group, also proved popular, but their use led to herding – the portfolio follows what everyone else is doing but might bear no relation to a charity’s own requirements or risk tolerance. Such benchmarks are also backward looking, as the distribution of the benchmark is only apparent after the event. In the words of Acevo’s report of 2003, “a charity’s investment asset allocation should reflect its objectives and requirements, not the average allocation of a peer group of funds”.

A ‘targeted return’ approach abjures the use of benchmarks. Rather than judging performance against the FTSE or the WM, when a fund manager can still ‘outperform’ even if your portfolio were to deliver a dreadful return, this approach seeks to achieve real returns on a consistent basis. The target itself should tie in with what the investing charity actually wants to achieve – which should be clear from its policy statement. This might be a total return of a margin above cash or inflation, perhaps with a specific income requirement as well.

The key to achieving this target can be found in academic research which points to asset allocation being the main determinant of portfolio returns. Benchmarks do provide for diversified asset allocation but this is largely passive – it is an average, after all. Indeed, often charities have simply split their portfolios between bonds and equities. A study by the Institute for Philanthropy indicated that “some organisations are operating in a ‘comfort zone’ by taking familiar investment decisions rather than pro-actively seeking to implement potentially more profitable and more diversified investment strategies”. The same study found that those charities with more diversified portfolios realised returns of 0.9-1.6 per cent higher than those whose portfolio contained 60 per cent or more in equities between 2002 and 2007.

The example of Yale Endowment is instructive: in 2008 it had 25 per cent in hedge funds; 20 per cent in private equity, 29 per cent in ‘real assets’ ie oil and gas, property and timber, but only 29 per cent in bonds and equities. It achieved a ten-year average return of 16.3 per cent versus 4.4 per cent from a 60/40 allocation to US equities and bonds.

However, even the Yale Foundation fell some 25 per cent in the year to 30 June 2009. David Swenson, Yale’s investment chief, said in his defence that: “There isn’t an investment strategy that can produce the kind of long-term results we’ve generated at Yale that isn’t going to post the occasional negative return…Judging a long-term investment strategy based on the results of a five-to-six-month period is foolish beyond words”.

This should lead to a more nuanced approach: the achievement of the best available risk-adjusted returns with the possibility of losses in the short term. Otherwise investment in ‘safer’ assets to avoid negative returns may provide disappointing capital growth, generally scarcely above inflation, over the long term.

Furthermore, there should be no obligation to invest in asset classes if there is no rationale for them, simply to have a ‘diversified’ portfolio. Sometimes the best way to cut risk is to reduce diversification in favour of cash. Cash is often seen as the poor relation when allocating assets, but, to quote Warren Buffett, “Holding cash is uncomfortable, but not as uncomfortable as doing something stupid.”

James Codrington is head of charities at Baring Asset Management