Charity investors being better prepared for the future

Scenario analysis, modelling the likely returns of various asset classes under a variety of possible investment scenarios, has become an increasingly important tool in building robust portfolios, aligned to the needs of individual charities. It can help identify real world risks, but also help charities decide on the right asset mix to achieve their long term goals. It is a means to take a more granular approach to investment planning, leaving trustees better prepared for the future.

Just as driving by looking in the rear view mirror is not to be recommended, assuming that investment markets will behave in future as they have done in the past has its limitations. It leaves an investment strategy vulnerable to unexpected events or changes in economic policy. Instead, investment managers need to incorporate a view on likely future events and their impact on financial markets. The financial crisis exposed an over‐reliance on historical statistical relationships with many portfolios found to be poorly diversified when it hit.

More considered approach

Taking a more considered approach to portfolio risk and diversification has become particularly important in recent years, where the impact of extraordinary monetary policy and quantitative easing has distorted returns from financial markets. It means that the future return profiles from various assets are unlikely to be the same as they were in the past. This is particularly true for the bond market. Building scenarios and modelling the likely returns from asset classes under those scenarios can help create more robust, “future proof” portfolios.

Different currency scenarios

This is also important in managing risk and “stress-testing” portfolios. For example, scenario analysis might look at how the portfolio would react to a sudden spike in the oil price. This can help identify if the portfolio is insufficiently diversified, or has a lack of balance. More recently, this has been important in testing portfolios’ sensitivity to various different currency scenarios, notably around Brexit.

It has been used to show the impact of a 25% appreciation and 25% depreciation in sterling on portfolio value. It could also look at how changes in interest rates might impact portfolio income or capital returns.

For charities, scenario analysis can also help identify and meet their specific needs. For example, scenario analysis can help establish a charity’s future cash flow and investment needs to better align its investment strategy. One can look at the likely outcomes given a range of different financial market scenarios to manage risk and ensure that the charity does not run short of cash should markets turn down.

Assessing drawdown exposure

It can also be used to help charities decide between various different scenarios. For example, it can help to visualise the type of drawdown exposures a charity may be exposed to by taking a specific asset allocation/return target. To reach CPI+3% return target in the present interest rate environment one would usually recommend a weighting of around 60% in equities.

Running a scenario analysis for the 2007-2009 global financial crisis on that asset allocation showed that the portfolio would have experienced a maximum drawdown of around 25%. If a charity is uncomfortable with that level of volatility, or wouldn’t be able to meet its commitments, it may be worth looking at a different allocation.

Scenario analysis can also show the impact of different fee rates and market returns on a portfolio’s value. This can help charities look at the “value for money” element of active investing and how they want to balance active and passive investments in their portfolio. It can also help demonstrate what could be achieved by taking additional risk. In this way, scenario analysis can help build a more nuanced and tailored portfolio that works for the individual needs of each charity.

Removing behavioural biases

It can also be important in helping to remove the natural behavioural biases that afflict all investors. One spends a lot of time trying to understand how certain behavioural traits – from an inclination to run with the herd, to “confirmation bias” (where investors interpret evidence to support their prior beliefs) – could affect portfolio returns. This helps eliminate them as far as possible when investing.

Scenarios help with this. If an event, such as a spike in the oil price, has been planned for and a course of action laid out, it prevents “on the hoof” decision-making, which is where investors are particularly vulnerable to behavioural biases. If the course of action has already been laid out, it means decisions are well-considered.

Forward‐looking scenario analysis is a good way to uncover the real risks and upside potential of an investment portfolio, capturing the portfolio’s sensitivity to specific, real world events. It offers a powerful insight into risk, and allows trustees to understand the impact of different market environments and withdrawal profiles on portfolio value.

Scenario analysis in practice

This example shows how scenario analysis can be used by trustees to visualise investment risk and returns in real life terms, providing an important tool to inform strategy discussions. The charity in question was based in the UK and worked in the education sector. The charity had raised a lot of money, but was spending it quickly. The remaining pot was disappearing and the trustees thought one solution may be to move into higher risk assets to grow the pot faster.

A scenario was modelled for the charity to show the problems inherent in taking more risk with the charities’ reserves. This was how it worked:

SCENARIOS. The charity’s portfolio is currently 65% invested in equities, with the balance split equally between UK bonds and alternatives. The primary investment objective is to grow the portfolio ahead of inflation. The charity is budgeting net annual withdrawals of £525,000 (increasing with an inflation rate of 2%). With a current portfolio size of £10m this represents an initial withdrawal rate of 5.25%. A relatively simple scenario analysis was undertaken modelling the portfolio value, taking into account the inflation adjusted withdrawals, under three different market return scenarios, as follows:

BASE SCENARIO. Returns from equities, bonds and alternatives are 7%, 2% and 5% respectively.

BULLISH SCENARIO. Returns from equities, bonds and alternatives are 10%, 2% and 7% respectively.

BEARISH SCENARIO. The first 22 months of returns repeat the 2007-2009 financial crisis, followed by base scenario returns in perpetuity.

RESULTS. The graph below shows the results of the scenario analysis:


Source: including DataStream/Bloomberg as at 31 December 2017.



The annual withdrawals are equal under all three scenarios, but the different market environments lead to dramatically different portfolio values. Under the base case scenario the portfolio maintains its nominal value, but in real terms it does not keep pace with inflation. Under the bullish scenario the portfolio manages to meet the annual withdrawal requirements and grow ahead of inflation.

Greatest insight into risk

But the bearish scenario provides the greatest insight into risk. When the portfolio experiences an initial loss the annual withdrawals become a larger proportion of the total value, and effectively lock in the initial negative returns. Even though the portfolio experiences “base case” returns afterwards the value never recovers from the initial loss, and reaches a £0 value in 2037.

OUTCOME. The scenario analysis suggests that the level of withdrawals is incompatible with the growth ahead of an inflation objective unless the market environment is very supportive. It is reasonable to ask whether the market environment is likely to be supportive after a lengthy bull market in equities, with stock market valuations near long term highs.

It also highlights the impact that withdrawals can have in permanently impairing value in periods of market volatility. The trustees ultimately concluded that an increase in the portfolio’s risk level would not be appropriate given the sensitivity to short term losses, and indeed portfolio risk was actually reduced slightly. A new fundraising strategy was also implemented to increase income and in turn reduce the level of portfolio withdrawals.

Reality of investment risk

THE IMPLICATIONS. Investment managers typically talk about risk in technical terms like standard deviation or tracking error. But these short term metrics fail to capture the day-to-day reality of investment risk for trustees. By using basic scenario analysis one is able to demonstrate how different market environments, risk profiles and withdrawal amounts influence the portfolio’s value and can inform important discussions on the right risk profile for a charity.

Scenario analysis is a potent tool in helping to deliver better, long-term outcomes for charities. It allows for a more granular and detailed understanding of risk and potential rewards, while bringing real world scenarios to bear on the investment strategy. It is a valuable part of the way portfolios are constructed.

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