The credit crisis which is currently unsettling world financial markets has occurred at a time when risks should be low. The economy is growing at a reasonable rate, inflation is under control and interest rates, which had been rising, are at or even below their peak. Although there have been some areas of concern – the oil price for example – these have not been sufficient to threaten the overall benign picture. The source of the problem is unusual too. The contagion has not brewed up in emerging markets but has developed in the financial industry at the centre of the world economy. In this article we examine the causes of the crisis, set out our current understanding of the scale and consider what charities should do with their investment portfolios. 

 

 

In recent years, banks and other financial companies developed complex new investment products allowing them to parcel up risky loans and sell them on to investors. As a result of the excess liquidity in the financial system there was huge demand for these products. This effectively led to the creation of a secondary banking system running in parallel to the traditional model. The credit available from this demi monde of the financial markets fuelled a boom in asset prices, funded takeovers and private equity, helped push house prices higher and influenced commercial property prices.

 

As problems emerged earlier in the year, it became apparent that what at first had seemed to be a shortage of liquidity in the day-to-day money market was in fact the collapse of this secondary market. 

 

As it became clear just how profound the problems were, the world’s central banks began to take supportive action. Recent news of concerted and co-ordinated action by the Bank of England, the European Central Bank and the US Federal Reserve should remove any lingering concerns that they are not doing enough to help markets over the liquidity problems. But although they have made borrowing easier, what they have not done is to take on the risks of imprudent lending. That rests still with the banks or the buyers of products and understanding the implications of that gives the key to the next phase of the crisis. This is because although investors have some insight into the scale of the crisis – and it is massive, over $200bn of losses on products associated with sub-prime US mortgages alone, there is scant information on who is exposed to it. In effect, the repackaging of loans that occurred when the new financial instruments were constructed wiped out the trail of where the liabilities were. As a result there is a marked reluctance to lend to any but the strongest counterparties. The potential problems that this can cause are illustrated by the first run on a domestic bank for 140 years when Northern Rock, a mortgage bank removed from the lending practices at the heart of the crisis but dependent on the market for the bulk of its funding needs, found those markets closed.

 

 

Although our understanding of the situation is improving, it is still far from complete. A number of banks have put a sum on their exposure to losses but several have subsequently revised this sharply higher. We also know that banks are not the only institutions involved but have heard nothing from the insurance companies, pension funds or the hedge fund community, all of whom have been involved to some extent.

 

What this means for charity investors is that markets will remain fearful for some time yet and that some of these fears will be justified. It is therefore a good time to review portfolios to ensure that risk exposures are intended and justified by the potential for returns associated with them.

 

 

A good place to start is with cash deposits as most charities will have some allocation to deposits and many will only have cash investments in their portfolio. A key message from recent months has been that investors who target a return above the ‘risk free rate’ provided by government bonds, do so in absolute clarity that they are taking a higher risk too. For charity trustees simply seeking a good return on their funds this is a hard lesson. For example, it raises a question of whether any policy of lending cash to a single institution – perhaps a high street bank, can be described as prudent. 

 

The alternative that stands out in these circumstances is a deposit fund. A deposit fund pools the resources of its investors to achieve institutional scale and institutional interest rates. Importantly, it spreads these deposits across a number of borrowers, each themselves of good quality. If the risks of loss from a good quality borrower is low, the risk of many having difficulties at the same time is remote. So low in fact that the best of these deposit funds can achieve the coveted ‘AAA’ status from credit rating agencies such as Moody’s.

  

 

The theme here is diversification of risk and this is a concept that remains relevant when we consider a sensible strategy for equities. Many charities have an equity portfolio which is heavily weighted towards the domestic market. The reasons for this can include the historic benefit of tax advantage or more conceptual beliefs that the home market produces the best income or is lower risk. These views are outdated. Too great a focus on the UK market can give rise to a level of risk in the fund which is unrecognised by the trustees. The problem is that the UK market has become very concentrated in recent years. The top five sectors account for over half the market’s capitalisation. The top two nearly thirty per cent. The top ten companies alone account for around a third of the entire market value. This level of concentration not only increases the risk of the fund it also reduces the opportunities available to investors because a number of important sectors are not represented to any meaningful degree. Where are the UK’s consumer electronics giants? Its motor industry? Its tech companies? To the extent that these sectors flourish in an environment of rising consumer affluence, UK investors will miss out. In addition, there is the issue of income. Not only are yields in overseas markets much closer to that on the UK than many investors recognise but the growth rate in that income is far greater. For charities charged with being even handed between current and future beneficiaries, it is important to consider overseas investment as a means of maintaining the real spending power of their disposable income. 

 

  

An area which has been much in vogue in the recent past is property – justifiably so given the strong returns it has produced. Because property performs differently to equities, cash and bonds, it is a good diversifier of portfolio risks and so will help smooth the pattern of investment returns. However it has also been a major beneficiary of the easy money flows of recent years and faces a much less certain future in a world of credit shortage. Trustees who use property funds need to review their exposure to the sector. Property is not a liquid asset. In the best of times buying and selling takes weeks if not months and in difficult markets the process of matching buyer and seller can be extended. If property disposals are earmarked for the near term then work needs to be done to understand the likely timescales of any sales activity, realistically price expectations need to be reviewed too. If capital values are less secure, then funds which gear – that is borrow to increase their exposure to the underlying assets – will suffer more. Trustees need to be sure that this amplified exposure suits their needs and if not take action. However, whilst the capital values in the property sector are less attractive at the moment, the potential to provide a reasonable and rising income should not be overlooked. Lower property prices mean higher yields for investors and through active management and sensible positioning a well managed fund should be able to keep distributions rising in the months ahead.

 

 

What seemed to be a local difficulty in financial markets has been revealed as something much more troubling and far reaching. Latent risks have become real risks, investment returns have become much harder to win. Trustees of charities large and small need to consider how closely their investment strategy meets their objectives and within that make sure that the trade off between risk and return has an appropriate balance. This is not a time for drastic action but it is one for prudent review. Small changes in approach can produce a big change in outcome.

Author: James Bevan

James Bevan is chief investment officer at CCLA Investment Management Limited.

www.ccla.co.uk

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