Sum of the parts
May 2010 supplement
Performance of investment portfolios is a significant area of risk for charities. Clarissa Dann summarises the key areas of exposure and how to mitigate them
Charities have to balance their current and long-term needs on something of a tightrope when it comes to investment management. And getting it wrong does very little to inspire potential donors. This short summary of investment risk and how to manage it has been put together with the help of members of the Charity Investors’ Group, whose details are listed at the end of this article.
One of the key areas of financial risk is the performance (or lack of it) of investment portfolios. In other words, charities need to monitor and manage the risk that the investment strategy selected does not meet their long-term objectives. One only has to look at the recent cautionary tale of the Church of England’s £40m loss on a disastrous investment in a New York apartment complex that was acquired by a consortium in 2006 for $5.4bn. The entire value of the investment had to be written off. The Icelandic banks saga is also still fresh in certain charities’ minds[1].
Counterparty and investment risk
Richard Maitland in The Compendium of Investment [2] makes the point that an investor faces two types of risk: ‘counterparty risk and investment risk’ (see page154).
Counterparty risk
This is the risk of failure on the part of the bank, stockbroker or investment manager who conducts transactions for the investor and may also hold the investor’s securities and cash balances. For example Lehman Brothers was a global counterparty and it going bust caused havoc with many investors, some of which may not be able to reclaim their assets in full.
This is the risk of failure on the part of the bank, stockbroker or investment manager who conducts transactions for the investor and may also hold the investor’s securities and cash balances. For example Lehman Brothers was a global counterparty and it going bust caused havoc with many investors, some of which may not be able to reclaim their assets in full.
Investors are protected by the fact investment managers hold charity assets to their clients’ order rather than their own ‘so the assets are ring-fenced and the clients are protected’ in the event of failure. Maitland explains: ‘auditors and regulators exercise close supervision over the whole financial services sector and there are compensation schemes in place.’
Investment risk
Investment risk needs to be considered over different timeframes and from both a real and absolute standpoint and is the risk that is inherent in the investments themselves. In one sense, investment risk means the danger of a particular asset within an investor’s portfolio failing and it becoming worthless. However, this is a narrow definition of risk since it deals only with the extreme form of risk and, if the investor wishes, risk of this nature can be reduced by diversification to the point
where any one single asset failing does not really matter.
Investment risk needs to be considered over different timeframes and from both a real and absolute standpoint and is the risk that is inherent in the investments themselves. In one sense, investment risk means the danger of a particular asset within an investor’s portfolio failing and it becoming worthless. However, this is a narrow definition of risk since it deals only with the extreme form of risk and, if the investor wishes, risk of this nature can be reduced by diversification to the point
where any one single asset failing does not really matter.
If one holds, say, just six equity investments of equal value, the failure of one of them requires the other five to each rise by 20 per cent to restore the value of the portfolio. If one holds, say, 50 investments of equal value, the other 49 need only rise by 2 per cent each to restore the position to the day before the ‘disaster’. And it goes without saying that some forms of investment are riskier than others.
Other investment risk includes losing money in the absolute sense and risk of losing money against inflation. This depends on the investment objective of the organisation.
Investment objective risks
Further information on risk as part of the overall investment management policy can be found in Caritas, Guide to Finance, June 2009,
page183. This article makes the point that the charity’s investment strategy must align with its charitable objects. For example a grant-making foundation will have an entirely different approach from a charity delivering contracted out services. The main investment objective risks are:
Further information on risk as part of the overall investment management policy can be found in Caritas, Guide to Finance, June 2009,
page183. This article makes the point that the charity’s investment strategy must align with its charitable objects. For example a grant-making foundation will have an entirely different approach from a charity delivering contracted out services. The main investment objective risks are:
1) Risk that capital does not keep pace with inflation
This is the risk that higher prices over time will diminish the real value of an asset. This is true of savers who have cash in the bank – the value of their money will be ‘lower’ in the future. Examples include Germany back in the 1920s and, most recently, Zimbabwe.Equity markets over the long term (110 years) are expected to generate inflation plus 5 per cent, but over shorter time periods returns can be significantly different. For example, the FTSE 100 only returned 1 per cent per annum in the period 2000 to 2009 in total (capital plus income) and lost 2.4 per cent per annum in capital terms as compared to inflation of 2.7 per cent.
This is the risk that higher prices over time will diminish the real value of an asset. This is true of savers who have cash in the bank – the value of their money will be ‘lower’ in the future. Examples include Germany back in the 1920s and, most recently, Zimbabwe.Equity markets over the long term (110 years) are expected to generate inflation plus 5 per cent, but over shorter time periods returns can be significantly different. For example, the FTSE 100 only returned 1 per cent per annum in the period 2000 to 2009 in total (capital plus income) and lost 2.4 per cent per annum in capital terms as compared to inflation of 2.7 per cent.
2) Capital volatility
Investors seeking capital growth rather than just a steady income from their investments have to accept a higher risk of losses. However, investment markets are volatile which makes budgeting for capital movements difficult. In any one year returns from an asset can be significantly different than the long-term expectations. So volatility needs to be considered over periods other than one year and in ‘real’ terms – what looks risky (i.e. volatile) in the short term might be quite the opposite for a long-term investor.
Investors seeking capital growth rather than just a steady income from their investments have to accept a higher risk of losses. However, investment markets are volatile which makes budgeting for capital movements difficult. In any one year returns from an asset can be significantly different than the long-term expectations. So volatility needs to be considered over periods other than one year and in ‘real’ terms – what looks risky (i.e. volatile) in the short term might be quite the opposite for a long-term investor.
Volatility creates risk because it exposes you to the vagaries of short term market pricing. If you need to sell your investment in a falling market, you will have to realise the loss. If you are unlikely to need to sell your investments then in theory you are able to tolerate this volatility of capital in order to achieve the benefit of a greater expected return over the long term. This is why time horizon is important in determining your investment strategy. You may also have to state unrealised losses/gains in your accounts and it is also worth bearing in mind the impact of this on donors and/or trustees.
3) Income volatility
Investors seeking a steady income from their investments are also exposed to risk as income is also volatile, although arguably more predictable than capital returns. It is not only higher risk investments that produce more volatile income, as can be seen with cash rates over the last five years which have ranged from 6 per cent to 0.5 per cent. Over history, dividend income tends to increase as GDP grows and company earnings increase. However, year-on-year changes can also be volatile. In 2009, dividend income from the UK equity market was down by around 20 per cent as companies held onto cash in difficult economic times and the bailed-out banks were prevented from distributing dividends until the government had been repaid. But generally, the fall in inflation and therefore interest rates reduced income returns from the levels they were in the past.
Investors seeking a steady income from their investments are also exposed to risk as income is also volatile, although arguably more predictable than capital returns. It is not only higher risk investments that produce more volatile income, as can be seen with cash rates over the last five years which have ranged from 6 per cent to 0.5 per cent. Over history, dividend income tends to increase as GDP grows and company earnings increase. However, year-on-year changes can also be volatile. In 2009, dividend income from the UK equity market was down by around 20 per cent as companies held onto cash in difficult economic times and the bailed-out banks were prevented from distributing dividends until the government had been repaid. But generally, the fall in inflation and therefore interest rates reduced income returns from the levels they were in the past.
As the Compendium puts it: ‘This is a serious problem for many charities. It has led to a growing debate in the charity movement about the extent to which it might be safe to top up income by spending some of their accumulated capital gains if they are free to do so [4].’
Market risks
Major external events
When adverse events cause a particular market to behave in an irrational manner, such as a major sell-off following bad news or vice-versa. Often this can be caused by an unrelated risk such as geopolitical or political risks (such as 9/11 in 2001). Negligence, corruption or mismanagement of an investment can also cause a loss of value and significant market risk – for example the panic selling following Northern Rock, Enron and Madoff.
Major external events
When adverse events cause a particular market to behave in an irrational manner, such as a major sell-off following bad news or vice-versa. Often this can be caused by an unrelated risk such as geopolitical or political risks (such as 9/11 in 2001). Negligence, corruption or mismanagement of an investment can also cause a loss of value and significant market risk – for example the panic selling following Northern Rock, Enron and Madoff.
Liquidity risk
This is the risk of not being able to sell or buy when an investor wants as an investment may be readily saleable on the open market (e.g. commercial property) or the market has a small capacity and may therefore take time to sell. This is very relevant to charities that held certain hedge, property and private equity funds in 2008.
This is the risk of not being able to sell or buy when an investor wants as an investment may be readily saleable on the open market (e.g. commercial property) or the market has a small capacity and may therefore take time to sell. This is very relevant to charities that held certain hedge, property and private equity funds in 2008.
Interest rate risk
This is mainly an issue for bonds or loans that pay a fixed interest to the lender. As interest rates rise, the price of a fixed rate bond will fall, and vice-versa.
This is mainly an issue for bonds or loans that pay a fixed interest to the lender. As interest rates rise, the price of a fixed rate bond will fall, and vice-versa.
Currency risk
This is when assets are invested in another currency and there is a risk that currency movements alone may affect the value [5].
This is when assets are invested in another currency and there is a risk that currency movements alone may affect the value [5].
Reinvestment risk
If you need to sell or redeem and invest, there might not be a similarly attractive investment available. This is common with bonds that pay a fixed interest, say an annual coupon of 8 per cent which matures and a similar bond is only available at four per cent (clearly linked to interest rate risk).
If you need to sell or redeem and invest, there might not be a similarly attractive investment available. This is common with bonds that pay a fixed interest, say an annual coupon of 8 per cent which matures and a similar bond is only available at four per cent (clearly linked to interest rate risk).
Property risk
Many charities own and let buildings as investments and they are often managed by the charities themselves rather than investment managers. The risks here are voids – i.e. periods in which the buildings are not let and obsolescence. The latter causes problems when they buildings cannot be sold or re-let without significant capital sums being spent on them. Further more, changes in environmental law are impacting on building standards and the costs of updating requirements.
Many charities own and let buildings as investments and they are often managed by the charities themselves rather than investment managers. The risks here are voids – i.e. periods in which the buildings are not let and obsolescence. The latter causes problems when they buildings cannot be sold or re-let without significant capital sums being spent on them. Further more, changes in environmental law are impacting on building standards and the costs of updating requirements.
Investment selection risk
If the selected investment underperforms the market, the charity is exposed, so this includes the risk of holding poor portfolio components or picking underforming stocks.
If the selected investment underperforms the market, the charity is exposed, so this includes the risk of holding poor portfolio components or picking underforming stocks.
Asset allocation and stock selection risk
This is the risk that your or your investment managers’ opinions on the relative attractiveness of each asset class proves to be incorrect. In turn this leads to under-performance of the whole investment plan, so even if you have selected the right overall strategy (for example, how much to allocate to cash, bonds and equities), you may still not meet your investment objectives.
This is the risk that your or your investment managers’ opinions on the relative attractiveness of each asset class proves to be incorrect. In turn this leads to under-performance of the whole investment plan, so even if you have selected the right overall strategy (for example, how much to allocate to cash, bonds and equities), you may still not meet your investment objectives.
There is also a risk that your selected equity/bond/cash deposit does not perform as well as the overall market. This can be mitigated to a certain extent through portfolio diversification which spreads the risk.
Charities also need to be aware of cost risk, in other words that the layering and hidden charges in the investment detracts from the return. They also need keep an eye on benchmark risk. Tracker or index funds are popular with some charities because this removes the risk of an active manager (i.e. the one selecting the stock) underperforming the benchmark.
If an investment is made outside the guidelines set by the charity trustees, a mandate risk will emerge. For example, perhaps the trustees have specified the minimum counterparty rating for cash deposits or no exposure to tobacco manufacturers. This can be mitigated through frequent reviews and risk controls with investment managers.
Measurement techniques
Standard deviation
This is an arithmetical measure of variability, so the wider and more variable the range of the returns that an investment displays over time; the greater is the inherent risk, demonstrated by the higher standard deviation of its return. Similarly, the lower the standard deviation, the lower the risk. Although common sense would suggest that shares are more volatile and therefore riskier than gilts, both are riskier than cash on deposit. Using standard deviation as a measurement tool, it becomes possible to quantify this difference and relate it in a scientific way to the returns that these and other forms of investment offer.The principle is illustrated in figure 1, which shows the price behaviour of a highly volatile investment ‘A’ and figure 2, which shows the price behaviour of a low-volatility investment ‘B’.
Standard deviation
This is an arithmetical measure of variability, so the wider and more variable the range of the returns that an investment displays over time; the greater is the inherent risk, demonstrated by the higher standard deviation of its return. Similarly, the lower the standard deviation, the lower the risk. Although common sense would suggest that shares are more volatile and therefore riskier than gilts, both are riskier than cash on deposit. Using standard deviation as a measurement tool, it becomes possible to quantify this difference and relate it in a scientific way to the returns that these and other forms of investment offer.The principle is illustrated in figure 1, which shows the price behaviour of a highly volatile investment ‘A’ and figure 2, which shows the price behaviour of a low-volatility investment ‘B’.
Bond credit ratings
Investment risk can also be checked by bond and sovereign debt credit ratings which assess the health of a corporation’s or country’s debt issues – rather like credit ratings for individuals and countries. Credit ratings are assigned by credit rating agencies such as Moody’s and Standard and Poor’s, with each rating having letter designations such as AAA (highest quality) and BBB/Baa (below which bonds have ‘junk’ bond status. For example, Standard and Poor’s downgraded Iceland’s sovereign debt from A- on 29 September 2008 to BBB by 10 October of that year.
Portfolio risk management – the essentials
By understanding the risk and return characteristics of different asset classes, investors can create portfolios with different risk profiles. This is a key part of portfolio theory and of the benefits of diversification. For example, investors seeking lower risk returns will tend to invest a greater proportion of their portfolios in low-risk assets such as bonds or cash which are less volatile than equities.
By understanding the risk and return characteristics of different asset classes, investors can create portfolios with different risk profiles. This is a key part of portfolio theory and of the benefits of diversification. For example, investors seeking lower risk returns will tend to invest a greater proportion of their portfolios in low-risk assets such as bonds or cash which are less volatile than equities.
Further analysis of portfolios is possible using a variety of calculations including Sharpe ratios[6], beta, information ratios, VAR (a measure of probability of loss beyond a certain level). All of these are used to characterise the relationship between risk and return in portfolios and investments.
The Holy Grail is to construct portfolios that provide high returns with low volatility. The rise of the hedge fund industry is in part an attempt to address this although their high fees can significantly eat into returns over time. And it goes without saying that professional advice should be sought when constructing a portfolio to ensure that the investments selected are appropriate for the charities objectives and risks associated with them are understood by the trustees.
[1] See ‘The long slow thaw’ in Caritas, November 2008, issue 12, page 4. www.charitiesdirect.com/caritas-magazine/the-long-slow-thaw-162.html
[2] Published by Sarasin in March 2010. Available from www.ico.gov.uk
[3] www.charitiesdirect.com/caritas-magazine/how-to-develop-your-investment-strategy-452.html
[4] See page 109 of the Compendium of Investment 14th edition
[5] See also Andrew Derry’s article ‘Currency speculation or risk management?’ in Caritas January 2010, issue 26 page 16 to 18
[6] The measure of the excess return (or risk premium) per unit of risk in an investment asset or a trading strategy, named after William Forsyth Sharp
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
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