Forecasting realistic charity investment returns

As human beings we are accustomed to using the past as a guide to the future. It is what experience means. However, we often extrapolate short term trends into long term predictions and find historical precedents to support our wishful thinking.

As charity trustees, you need to have a reasonable idea of what sort of investment returns to expect in order to be able to plan out future spending. It is only natural for trustees, in this situation, to use past returns as a guide. However, there are several reasons why this may not be such a good idea, particularly following the longest bull market in living memory.

Perhaps the most obvious reason not to do so is that future economic conditions are unlikely to mirror dynamics of the past. For example, given the current low level of interest rates, it is highly unlikely they could fall in the same way they did in 2008 when they declined from 2% to 0.5%. If that were to happen, we would see negative rates across the world.

Risk free

This is important because of the impact it has on the risk free rate of return. Historically the return on risk assets reflected a premium above the rate of return for taking no risk (i.e. cash). This is known as the risk free rate of return.

However, lower interest rates and low inflation mean the risk free rate of return, after inflation has fallen significantly. Between 1980 and 1994 the risk free rate after inflation was 3.4%. It is currently -1.0%. Therefore, if the excess return on risk assets remains reasonably constant then a lower risk free rate of return means lower returns from all asset classes.

The period since 2008 has also seen a new economic phenomenon, quantitative easing. QE is a massive expansion of the open market operations by a central bank. It is a strategy used by central banks to stimulate an economy by making it easier for businesses to borrow money.

To do this the bank buys securities from its national banks to add liquidity to capital markets. This has the same effect as increasing the money supply. In return, the central bank issues credit to the banks' reserves to buy the securities. This lowers interest rates and is designed to encourage economic growth.

This encourages borrowing and pushes investors to take greater risks, as low interest rates suppress investment returns for the reasons set out above. As a result asset prices rise as the amount of money invested increases.

Sheer size

To get an idea of the impact of QE over the last ten years, it is important to remember the sheer size of the monetary stimulus involved. The US Federal Reserve, the US central bank, added almost $2 trillion to the US money supply with its programme whilst, until recently the European Central Bank’s asset purchases ran at €60 billion a month.

The ending of these programmes and the start of a now gradual sale of some of the bonds bought in these programmes is a significant change.

For these reasons the future is unlikely to be a reflection of the recent past but, can longer term data help? The answer is that whilst there are studies looking at over 100 years of data (the Barclays Equity Gilt Study for example) they are not a good guide to the near future.

If, for example, the median return from equities over the period covered by the Barclays Equity Gilt Study was over 10% but it includes periods such as the 1970s when interest rates were far higher than today. Those with long memories know interest rates reached 17% in 1979. Therefore, the return might be skewed by periods of very high inflation or interest rates and suggest a higher return than would be normal at times of lower inflation and interest rates.

Perhaps the more valuable result of the survey is the consistency of the relationship between the returns of various asset classes and the risk free rate.

Sensible ways

However, there are sensible ways of forecasting returns. These rely on established valuation criteria and return forecasts rather than “gut instinct” or earnings multiples without adjusting for inflation. These will include a calculation of return above the risk free rate. So, what do these approaches tell us?

The short answer is that returns are likely to be lower than those we have seen since 2008 given the different economic conditions and the impact of lower interest rates and inflation. Any calculation that does not take account of current conditions won’t factor in the factor in the same dynamics.

For example, it is forecast that developed world equities will return 5.5% going forward. The historical figure would have been closer to 7%. With interest rates already low a forecast for sovereign debt is only 0.5% and for high yield bonds only 4.4%. One is taking account of the impact of quantitative easing on recent valuations and the slower growth rates which are likely from this support being withdrawn and then reversed.

However, just as importantly, one doesn’t expect markets to be any less volatile than they have been in the past. Markets will continue to react to political and economic uncertainty and whilst returns will be suppressed there is no suggestion volatility will fall. Indeed, given the current level of political uncertainty, it might rise.

Political upheavals

This would be less of a concern if the economic and political outlook were relatively short term. However, it is difficult, given the UK’s own political upheavals coupled with the tensions between China and America, to be confident markets won’t see increasing volatility.

This suggests trustees face the unappetising prospect of managing investments for their charities with lower returns and continuing volatility.

Lower returns mean trustees may need to review spending plans going forward. This can be difficult particularly after a period of sustained spending increases. Fortunately, many charities have been able to build up their reserves and may be able to phase any change over an extended period of time as a result but conducting a review given the present circumstances, is an exercise trustees should not avoid.

There is another more important consequence of this forecast of lower returns in the future, which is an important reason why lower returns and unchanged or even increased volatility should concern trustees and prompt them to take action.

Longer recovery

Lower returns mean that when investment portfolios fall in value they will take longer periods of positive returns to recover those falls. This might mean market weakness having a quicker and more sustained impact on reserves.

It necessarily follows from this, that managing volatility in markets will be far more important.

This means trustees should not only seek to quantify the impact of lower returns on their spending plans but also review their investment policy and the risks they are taking.

The important point to bear in mind is that trustees need to balance risk and return. If the return is lower and volatility remains the same, the downside risk will have increased. It might therefore be best to look at a strategy which seeks to manage volatility better and achieve more consistent returns.

We are now at a turning point. The economic policies which drove attractive investment returns over the last ten years are coming to an end. For a number of reasons asset returns will be lower and volatility may even increase. At the same time there is little evidence the calls on charities will fall either.

Highly unlikely

On this basis, it is highly unlikely that a portfolio will achieve the same returns as it has done in the previous 10 years. Couple this with the risk that any event similar to 2008, triggered by economic and global financial dynamics, could have a significant impact on returns.

The combination of the two could have a greater impact on a charity’s reserves and spending plans than at even the upheavals of 2008.

One obvious conclusion must be that in such an environment managing a portfolio’s volatility becomes far more important in achieving a suitable longer term return objective.

All trustees wish to be good stewards of their reserves. Now is the time to review spending in the light of lower future return expectations and consider whether a change of investment strategy and approach is required in the light of a changing investment environment to successfully navigate the next few years.