Asset classes and portfolio components
June 2009 Supplement
Cash
Cash is defined as a short term deposit with a financial institution. There is no volatility of the capital value and a rate of interest is paid on the balance. The risk of a cash balance is mainly counterparty risk as depositors with Icelandic Banks are well aware. Although it is the most liquid of the assets with the lowest risk, it has the lowest real return in the long run. Cash equivalents are assets that are readily convertible into cash, such as money market holdings, short term government bonds or Treasury bills, marketable securities and commercial paper. Cash equivalents have a maturity of less than three months.
Gilts and bonds
Gilts are bonds issued by the government. Conventional gilts pay the holder a fixed cash payment (coupon) every six months until maturity, at which point the holder receives their final coupon and the return of the nominal (i.e. the original capital sum given to the government). Conventional gilts are denoted by their coupon rate and maturity year e.g. Treasury 5 per cent 09/07/14. These provided a guaranteed nominal rate of return if held to maturity but there is variability in the capital value inbetween issuance and maturity and over time inflation erodes their capital value. For index-linked gilts both the coupons and principal are adjusted by the Retail Price Index.
Corporate bonds are issued by companies and have the same characteristics as gilts but with credit risk impacting the coupon and principal payments. Corporate Bonds tend to pay a higher coupon than government bonds (gilts) to compensate investors for the additional credit risk. Fixed interest securities are an important source of predictable nominal income for charities. Index-linked securities offer better inflation protection but lower levels of nominal income in the
near term.
Equities – UK and global
Equities are also referred to as stocks or shares and represent a share of the ownership of a company. Holders of equities are entitled to receive a share of the profits of the company, paid out as dividends. The likely success of a company is reflected in the price of the share, and is effectively a forward looking measure of expected profits. Equities have volatile capital values but typically a growing level of dividend income (even in most periods of recession).
Over the long term equities tend to offer the best return but the capital volatility in the short term means they are a higher risk investment.
Charities can access equities either directly (by buying shares on the stock exchange) or via pooled investment vehicles provided by their investment manager. Over the long term equities should produce capital and income growth and offer inflation protection. This asset class has outperformed cash and bonds over the long term but investors need to be able to tolerate short term volatility.
Hedge funds
These seek to maximise absolute returns using a broad range of strategies including unconventional and illiquid investments. Hedge funds span a large range of alternative strategies including global macro, directional, event driven, relative value and long-short.
Hedge funds in general are designed to have a low correlation to equity markets and as such are used within portfolios as a diversifier of risk. Although some have fared well in the recent downturn, the majority have struggled to protect capital values. Hedge funds are most commonly accessed by charities via a fund of funds, which has the benefit of diversification by manager and style.
However, charity trustees need to be aware of the less liquid nature of these investments, the higher fees and the opacity that makes ethical investment policies difficult to meet.
Property investment
Historically, property has been an asset class with low volatility and attractive returns over the long term. However, when the market does fall, it can fall significantly and there can be very limited liquidity. This makes it one of the longer term investments a charity will consider. Due to the large lot sizes, in order to diversify by asset and geography, charities often use pooled funds.
The charitable investor should distinguish between operating property which is used as part of the operations of the charity and would not be sold, and investment property. Operating property should be excluded from the ‘investment’ portfolio.
Structured products
This is a pre-packaged investment product based on derivatives.
Exchange traded funds
These are securities that track an index, a commodity or basket of assets like an index fund, but are traded on a main exchange. Prices of ETFs change through the day as they are traded, and because they trade like a stocks, they do not have a net asset value calculated each day in the same way a mutual fund does. These have the benefit of being a low cost way of getting access to a number of different asset classes (equities, commodities etc) but are only as good as the index they track (see active v passive on pages 18 and 19).
Others
Other asset classes that may be considered by charities include: commodities, private equity and infrastructure.
Author: Clarissa Dann
Clarissa Dann was the editor of Caritas as well as an HR and management online service,he People Bulletin until July 2011.
She is now the editor of the specialist trade finance magazine, Trade and Forfaiting Review which can be viewed at www.tfreview.com but does write on charity finance and investment from time to time.
Clarissa has a background in legal and professional publishing, as well as business journalism and holds an MBA from Cass Business School. She has been one of the judges for the non-profit category of the Chartered Institute of Marketing's Excellence in Marketing Awards for the second year running.
She has also acted as clerk to the trustees of a small almshouses charity and as a member nominated trustee to a pension scheme of a multinational publishing company.
Click here for other articles written by Clarissa Dann
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