Christian Flackett claims that charity investing is at a unique juncture and a complete change of mindset is needed.
While the challenges of old are as acute as ever, a huge potential transformation around the corner will require a complete change of mindset on the part of both trustees and investment managers.
How the charity sector responds to this is yet to be determined, but some basic investment principles suitable for a more liberalised charity investment landscape should be considered.
For now, though, it is worth revisiting the dual investment objectives many charities have to fulfil. Broadly speaking, these are to provide an income for the charity’s commitments and simultaneously to maintain the real value of their capital. In all but the most benign conditions these appear almost to conflict with each other.
While growing the endowment faster than inflation, charity trustees must also be able to distribute from it. Traditionally, the income element has been provided via investment in coupon-yielding bonds or company shares which return dividends to investors. This has usually been sufficient to cover the trustees’ dual responsibilities.
Today, however, a unique confluence of circumstances has conspired to increase reliance on charities, while at the same time dampening their ability to draw sufficient yield from their investments. While the global financial crisis did not create a technically defined depression, economic conditions remain subdued, to say the least. At an individual level, GDP income per head is still lower today than when the current UK coalition government took office while, at the national level, GDP remains 3.3 per cent below its first-quarter 2008 pre-crisis peak.
This has meant that wages have remained stagnant, which would probably be fine in itself had inflation not carried on unabated. Instead, it hit over 5 per cent year-on-year in September 2011. The result has been a near-universal deterioration in living standards for many families across the UK. This, along with a range of other trends, including energy price rises and a general retreat by government from welfare due to straitened circumstances, has meant that the pressure on UK charities is as great as ever.
Steady income?
Sadly, the investment landscape has offered no respite, with typical yields laid low by a variety of unique market factors. For example, government bonds could always be relied upon as source of healthy, risk-free returns. But since the early 1980s yields have charted a steadily downward course amid a set of benign conditions known as the ‘great moderation’. Currently UK and US ten-year government bond yields offer less than 3 per cent, which is very little when adjusted for inflation.
In the UK, the breakeven-implied inflation rate remains well above the yield offered by the conventional five-year government bond. In the corporate bond world things are little better. Yields stand at around 6 per cent as measured by the Barclays US Corporate High Yield index, but look at the historical context. This is much lower than before the global financial crisis when they stood at just under 10 per cent at the end of 2007. Corporate bonds are therefore expensive now and vulnerable to any rise in default rates, any perceived systemic risk (think Syria, Italy, US government shutdown) and any worsenin{{image:{"asset":"87194B6F-9AD3-4F21-AFB021C52C0B12AA","alt_text":"","dimensions":"","quality":"mediumPerformance","alignment":"auto","spacing":"5","copyright":"","caption":"","link":"","link_asset":"","link_page":"","link_target":"_self"}:image}}g of corporate profits. This is not to say that fixed income is a barren wasteland for charity trustees.
Alternative approaches, including insurance-linked bonds and carefully chosen subordinated debt of investment grade financials, could yield over 5 per cent in a consistent manner. But the obvious go-to areas are no longer so.
Equity dividends are the other main way to gain income. But again, approach with caution. Dividends are paid from cash, so a company must be profitable in the first place to be able to redistribute these earnings. There is also no commitment as such from a firm to give a dividend and for some they are an unpredictable special event and not to be relied on. Recent examples of this include Intercontinental Hotels and Ryanair. Companies also have many other competing demands for their cash, including acquisitions and capital expenditure. The latter has of course been famously restrained since the 2008 financial crisis as firms have been reluctant to spend when they can’t see into the future with any degree of confidence.
As economic conditions improve, so too will confidence and the willingness of companies to begin investing once again. Dividends may therefore become less of a priority. Turnaround stories and politically exposed companies also represent traps for the unwary dividend seeker. Take UK insurer Aviva, which slashed its dividend this year as new chief executive Mark Wilson sought to overhaul the firm and shore up capital. Meanwhile some sectors’ dividend programmes can suddenly be placed under threat by future governments with corporatist instincts. In September, the UK Labour party promised to cap energy bills for hard-pressed households. {{image:{"asset":"312B9DFB-941D-46E1-B6F12400CC00E440","alt_text":"","dimensions":"","quality":"mediumPerformance","alignment":"auto","spacing":"5","copyright":"","caption":"","link":"","link_asset":"","link_page":"","link_target":"_self"}:image}}
Three competing demands on the energy sector now include investing heavily for a lower-carbon future, paying out dividends to shareholders and at the same time potentially not raising tariffs after 2015. It doesn’t take much to guess which of the three is likely to give way first. This is not to say avoid UK dividends at all costs. It simply means finding the best and most consistent dividend-seeking managers out there has just become a little harder.
While the income landscape gets bleaker, respite could come in the form of seismic change in the charity sector. Earlier this year the Charity Commission launched its total return consultation, which cautiously suggested that trustees may more easily be allowed to adopt a total return approach to investment. This means that charities will be able to income-slice from a (hopefully) growing capital pot over time instead of relying on the vagaries of fixed income and dividend yields. This will require an entirely new skill-set because income slicing from a poorly invested capital base can lead to erosion in real terms over time.
An inflation-beating performance will be required, but with a relatively smooth trajectory so that withdrawals don’t bite during the natural troughs that affect all investment markets. The best approach over time must surely be a multi-asset portfolio with equities at its heart. Equities have tended to prevail over inflation and bonds over time because of their unique ability to monetise the efforts of human capital. In this sense they are the only true investment, with bonds simply making lenders out of their buyers.
And the case for equities remains compelling today, in particular thanks in part to strong corporate buybacks and robust investor inflows as memories of 2008 gradually fade. However, volatility is never far away in this asset class, as Syria, the collapse of the Italian coalition and the recent US shutdown have shown. Trustees, even adopting a total return approach, don’t have an infinite time horizon and will quite rightly wish to dampen down the bouts of volatility described. While equity returns are lumpy, charities’ requirements are more regular in nature. This is why a decent investment adviser will be needed in order to guide trustees around the minefield of capital preservation assets out there. Examples of this category that are working well at present include uncorrelated fixed income investments, such as selected long/short credit funds. Hedge funds arguably require even more selectivity, but some are still able to offer transparency, simplicity and true macroeconomic edge.