Foundations of a Robust Charity Investment Strategy: Thinking About Risk

This article continues our exploration of Strategic Investment Framework for Charities, a series of articles for charity trustees and executives that we develop in collaboration with Robert Hayes, a senior consultant to PMCL Consulting.

In our previous note we concluded by saying that ‘ideally your investments should reflect your aspirations’, in particular our focus was on cash flow requirements and potential commitments that a charity needs to plan for. The two crucial things that go together with aspirations are, of course, ‘fears’ and ‘opportunities’.

We will explore investment returns and the relationship with risk and the technical (and jargon laden!) topic of ‘investment risk’ in detail later in these papers. However at the outset it is helpful to consider the topic of ‘fears’ a bit more in plain English and consider the scenarios and situations that the trustees and institution wish to avoid.

What are we trying to avoid?

At the most extreme this could be some form of financial crisis that leads to a significant reduction in charitable activity or even closure.

But even before that extreme most charities will want to avoid or reduce the likelihood of outcomes such as:

• Being a forced seller of assets to meet commitments during a crisis. For example, having to sell equities during the Covid period due to a collapse in other income. Or finding yourselves unable to sell some assets when required. Volatility of asset values and liquidity of the assets therefore both need to be considered. As a general rule, anything that reduces your flexibility and means you are forced into having to take actions is preferably avoided.

• A public relations situation that adversely impacts the reputation of the organisation. This could be reputational around an inappropriate investment or ‘outsize’ losses or expenses or could be linked to a breakdown in relations with employees, beneficiaries or benefactors. All of which might be impacted by poor investment choices.

• Long term decline and loss of impact. This is probably the most subtle and difficult to judge as it typically arises gradually and is an outcome of factors such as inflation reducing real spending power. One scenario that can also occur is shifts in society or the economy that undermine the value of what might be regarded as ‘core assets’ such as property estates or significant commercial activities.

• Conversely it is also possible to be accused of lack of intergenerational equity by not being ambitious enough. ‘Reckless conservatism or caution’ has for example in the past led to some charities having very low risk portfolios or amassing ‘excess reserves’ which attract criticism.

How to incorporate negative scenarios in investment strategy?

Having spent some time considering what you want to avoid and potentially depressing yourselves with lots of negative scenarios the next step is to think how these views might apply to your investments in practice.

Most charities current investment portfolios and policy statements will incorporate comments about being low, medium or high risk and will often combine this with statements such as ‘we are a long-term investor’. We will expand on the topic of timeframes, measures of investment risk and all the maths and assumptions behind them in a later paper, but for the moment it is probably best to stick to simple rules of thumb.

Taking the examples above and thinking about investment policies to mitigate them would lead to you considering some of the following strategies.

Splitting the assets into a ‘reserves’ and ‘growth’ portfolio

This strategy is based on ensuring that you can cover a period of crisis or poor markets by drawing down the reserves and hopefully leaving time for the growth assets to recover. Thus avoiding the costs and risks of being a forced seller. How to invest the reserves and what actually constitutes ‘low risk’ is a key secondary consideration.

Managing reputation risks through a combination of specific controls over potentially controversial investments, good governance of your investments and diversification

• A common example of specific controls would be for health charities to preclude investment in tobacco companies.

• Good governance requires oversight by qualified people and the mitigation or avoidance of conflicts of interest. Investments in closely related businesses or outsize commitments to speculative property developments are sadly historic examples of where this has gone wrong.

• Finally the basic rule of ‘don’t have all your eggs in one basket’ and make sure you diversify your investments is always worth keeping in mind.

• Another issue that can arise is stakeholders may challenge trustees over ‘not doing enough’ and some expectations around how assets are invested in line with the ‘purposes and values’ of the organisation. The issue of ‘alignment’ is a topic which we will be returning to in detail but as the first stage it is useful to ask yourselves ‘are there any issues we need to be aware of or potentially take into account?’ as with the tobacco example above.

Managing inflationary risks and categorising assets in three 'buckets' in relation to inflation:

• Nominal investments such as cash and fixed income bonds which retain their nominal value but have no link or protection to inflation

• Inflation linked investments such as index linked bonds which have a specific link to measures of inflation (i.e. RPI or CPI)

• Real investments which are a broad category including equities and property where it is generally assumed that over the long term they will maintain their real value but you.

We will cover inflation in more detail in a specific paper later in this series.

Our Role in Supporting Your Investment Journey

Risk is an inevitable part of any investment and therefore rather than avoiding it the key point is that it should be ‘brought into the open’ and be explicit and deliberate so that trustees know what the risks are and why they are taking them. Charity trustees frequently have different levels of investment expertise but they are all collectively responsible for charity's assets as a board. An important part of our role is to help explain topics and ensure that all the trustees have an informed and constructive debate and understanding of their situation.

We find it is most important and useful to try to start the conversation with real world scenarios and situations since terms like ‘low’ or ‘medium’ are meaningless without context and data such as a ‘standard deviation of 8.7%’ whilst potentially interesting is useless without understanding how it might impact your activities.

Should your charity require professional support in any aspect of this process, we are here to assist. Our team is ready to discuss your specific needs and explore how we can contribute to your charity’s financial success. You can view client testimonials on our website for examples of the impact we've made with other clients.

Stay tuned for upcoming insights

Our subsequent articles will delve deeper into key topics:

• Finding the balance: Risk, Return and a bit of maths

• Developing the Plan: Transforming objectives and constraints into actionable policies

• Getting into the Nitty-Gritty: Practical implementation and ongoing policy management.