Addressing market volatility within investment manager relationships
Covid-19 is affecting more than just our health and happiness; the economic implications of the pandemic are now apparent with most sectors feeling the shockwaves. Sadly, charities are no exception, with many trustees concerned by how they can cope with the spectre of volatile markets and tumbling revenues. Even with governmental support, many charities will continue to struggle with increased demand and reduced income.
Reduced income isn’t the only financial issue that charities have had to contend with either. Many have felt financial pressure due to the volatility in the market. Like most investors, many charities will have seen their investments take a hit at the start of the pandemic, and while there are signs of recovery it’s likely to take some time to get back to pre-pandemic levels.
So how worried should charities be about this volatility, and how should they engage with their investment manager over these issues? At the same time, there are a number of other aspects which impact on responding to the volatility problem.
SETTING CASH REQUIREMENTS AND TIME HORIZONS. Ahead of engaging an investment manager, charity trustees should have a view of their cash flow over the next few years, factoring in both inflows and outflows from the investment portfolio. With this insight in mind, trustees need to be sure they have enough cash held separately to cover their expenses and any future projects during that period.
Important role
Investment horizons – or how long a charity can stay invested - play an important role in defining investment strategy. Trustees need to consider whether there’s likely to be a requirement to liquidate some or any of the portfolio, and, if so, roughly when this is likely to take place and how long the remaining sum needs to stay invested. If time horizons vary, it’s worth considering investing in separate portfolios which follow their own individual strategies.
Cash reserves help to improve tolerance and flexibility and provide a buffer against market volatility. This should be a fundamental part of any discussion for charities with their investment manager and not something that is considered only in extreme market volatility.
ABSOLUTE OR RELATIVE RETURNS – WHETHER THE RETURN OVER A CERTAIN PERIOD OR THE RETURN MEASURED AGAINST A MARKET BENCHMARK OR INDEX. At the start of a relationship with an investment manager, charities must consider exactly what their financial requirements are as this will impact the way in which the portfolio is invested. What a charity trustee will principally need to consider, alongside their investment manager, is the best approach for their portfolio - either absolute or relative. It is important to stress that there is no “right answer” to this question.
There are certain arguments in favour of each approach and some against. It is up to trustees to weigh up the respective advantages and disadvantages, and then make an informed decision having considered the charity’s individual requirements.
Investment flexibility
The absolute return approach typically involves investing in a relatively “unconstrained” manner. By unconstrained, the investment manager retains the flexibility to invest wherever they see as the best potential for returns (or, at the very least, the chance not to lose money) in any given market environment.
This approach is highly reactive to changing market conditions and gives the investment manager the ability to position the portfolio more defensively or aggressively as needed. It can be easy to align this approach to meet any objectives or required investment return. Indeed, a benchmark can be tailor-made to meet the precise goals of the charity. However, this approach is also very dependent on the skills of the investment manager - meaning there is potential for significant damage to the portfolio.
The relative return approach is less heavily reliant on “manager skill”. This does not mean to say relative return managers need little skill to do their job well. Rather, the benchmark for a relative return investor will tend to be biased towards real asset classes such as equities to ensure that the real value of the portfolio is maintained over time. This approach can also be compatible with an income-only approach - if the charity only draws down income from the portfolio rather than any capital growth.
STAYING INVESTED FOR THE LONG TERM. Many charities have much longer investment time horizons than pension funds or retail investors. So their strategy should be focused on financial sustainability. Indeed, while a private investor’s main goal could be outperforming the market, a charity is more likely to be focused on beating inflation. With such long term time horizons, there is much less need for charity trustees to focus on short term portfolio volatility.
Smoothing volatility
Generally speaking, volatility is smoothed over time, protecting the portfolio from extreme short term ups and downs. For those portfolios invested with a shorter time horizon, the risk of capital loss is heightened as there is less time for this volatility smoothing to kick in. Ideally, the minimum length of time to invest in equity markets is five years; most investment managers will be reluctant to manage portfolios for any shorter period.
Charity trustees will often work with investment managers to manage the charity’s investments and assets, and it can be helpful - particularly in times like these of extreme volatility - to have that expertise and knowledge aiding decisions.
MITIGATING THE IMPACT OF RECESSION ON CHARITIES’ INVESTMENTS. Volatility is not a new phenomenon. Markets have been behaving as they are now for decades, and fundamentally there is nothing particularly new with regards to Covid-19. Economic recovery may be slow following this crisis but it is still predicted to eventually normalise. However, as individual investors will know well, it’s hard to hold your nerve when markets are falling even if you know pulling out can be highly detrimental.
This, writ large, is the dilemma currently facing charity trustees as they try to safeguard the charity’s funds at a time of extreme market turbulence. So, having an experienced investment manager working with the trustees can allay concerns and help them to remain confident in their long term investment approach.
ESG (ENVIRONMENTAL, SOCIAL AND GOVERNANCE) INVESTING. Charity trustees have a duty to take ethical or other non-financial considerations into account when deciding how to invest for their charity. Specifics of this stewardship responsibility vary but once a benchmark is established, they need to ensure investment decisions comply with the framework as well as considering the effect of ethical or responsible investing on their potential returns.
Typically, ethical investing involves either a negative or positive screening approach, or a combination of the two. A negative screen rules out any companies involved in specific activities such as fossil fuels or weaponry. A positive screen selects companies with strong environmental, social and governance (ESG) policies. By investing ethically, charities can feel comfortable that the companies in which they are investing reflect their own values.
Different techniques
ESG decisions will play into the investment strategy of an individual charity. Every investment manager has slightly different ethical investing techniques, so it’s important to work with someone who understands the charity’s needs and values. Some managers integrate sustainable investing into their entire investment process, while others offer it as a separate service. Those charities which wish to invest according to their values should always ask how the investment manager will meet their requirements today, and how they plan to develop their service in future.
Interestingly, one positive takeaway from the pandemic is that ESG investments have been outperforming despite the volatility in the market, a trend we could see continue to rise as we become more ethically conscious. So, it’s a good opportunity to review holdings through this lens.
Ensuring investment strategy is effective and complies with corporate and fiduciary obligations is always challenging for trustees - even more so in such a time of unprecedented crisis. When the market is highly volatile, an investment manager can be instrumental in steering a steady course through challenging times, particularly if the trustee has limited markets knowledge. Here investment managers play a crucial role in reminding trustees that volatility is natural within the markets and that, provided the charity has a well thought out strategy, it is the long term performance which matters.
