Identifying risks and optimising returns

Written by Charles Milner & George Matthews. Economic and financial conditions have recovered over recent months, but the financial situation of many charities remains decidedly challenging.

| 4 min read

Lockdown restrictions mean normal income streams have fallen well below their pre-Covid-19 levels. However, buoyant markets have resulted in investment returns making up for at least some of the income shortfall from normal revenue sources such as events and face-to-face meetings.

The increasing significance of investment returns to a charity’s income means it is now more important than ever that the myriad of investment risks in their portfolios are identified and defined. Suitable actions can then be taken to optimise long-term investment returns.

Stock markets lost around a third of their value between mid-February and late March last year in the initial stages of the pandemic. However, many indices (including the S&P 500 and Germany’s Dax) have recovered to new highs, boosted by the huge fiscal stimulus delivered by central banks and the success of vaccine distribution in countries such as the US and UK.

This short sell-off period – driven by concerns over credit default, liquidity risk in some areas and even systemic risk – immediately turned around into a bull market. We have now seen an extended period where the main risk has been opportunity cost risk – i.e. the risk of being under-exposed to the market recovery.

A clear awareness of the risk of being under-invested was especially important last year, as even though the usual income sources for many charities were under significant pressure, it was vital for investment managers to be in close and regular contact with their charity clients. This ensured that the likely income requirements from such portfolios did not override or obscure the ongoing central aim of maximising long-term risk-adjusted investment returns.

There are plenty of other risks that are relevant to charity portfolios, including stock-specific risk, concentration risk, inflation/interest rate risk, and political and currency risks. There are also a whole variety of rather more human risks for charities and their advisers to consider such as how investment managers navigate reputational/career risks (for example do they cling too rigidly to a given benchmark and its asset allocations?).

There are also reputational risks for charities themselves in several areas. A prominent related area of risk for charities includes ethical factors, for example, a charity involved in animal welfare may want to be sure to avoid holding any share in a company that is involved in the testing of certain products on animals, or companies involved in betting. Such risks can be minimised by having a clear and regularly updated Investment Policy Statement, and a suitable ethical screening model.

However, the main investment risk in managing a portfolio is often adjudged to be volatility, which is monitored mainly by measurements of the volatility of individual holdings, and of the portfolio as a whole. Last spring, volatility measures went off the map, but it was precisely at this point that the optimal investment strategy was to take on as much risk as possible! Hence an approach that is overly dominated by volatility considerations can lead to disappointing returns.

A related issue is that it is vital that the investment time horizon is always taken into account when assessing the balance between risk and opportunity, and that short-term volatility considerations do not hold sway over what are usually long-term investment horizons. Indeed, with volatility can come opportunity.

In our experience, the effective investment time horizon for charities can often be longer than it might at first seem. As a result, arguably the biggest risk that some charities are consciously or otherwise taking is in taking too little risk, i.e. they are exposing themselves to sizable long-term opportunity-cost risks. A successful investment manager always needs to be able to pull together and weigh all these different kinds of risk against, what could be significant longer-term opportunities.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

Identifying risks and optimising returns

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