Planning for potential charity investment disaster
Looking around the world as seen through the lens of a news camera, we could be forgiven for being particularly pessimistic about life. The horrendous situation in Gaza, ongoing battles in Syria and Iraq, the awful downing of flight MH370 in the Ukraine amongst other disasters, reminds me of the line from W. Somerset Maugham's The Summing Up, "we live in uncertain times and our all may yet be taken from us".
Maugham was summing up his position as a humble writer in comparison to the extravagance of the wealthy, but the words could equally be attributed to the uncertain world in which we live. We tend to have short memories, but those who have lived through significant strife never forget the horrors they have experienced. As we commemorate the beginning of the First World War, the war to end all wars, it is worth reflecting that we have experienced considerable stress during the last hundred years.
Relating the geopolitical issues to investment markets, charities are like all other investors. They need to be aware of all risks and shocks that could affect their wealth. No trustee wants all to be taken away from their charity and they have a duty to preserve the assets that are entrusted to them.
Given the backdrop to the world today, should we be preparing for a collapse in markets or a prolonged bear market? After a very good year for investment returns in 2013, this year appears to have sobered up to headwinds that exist and broad markets have struggled to achieve positive total returns for the year to date.
Momentum building
Of course, this is only one side of the story. Momentum is certainly building in the US, which is the engine room of the global economy. Data out of the UK had almost unanimously been positive of late. Elsewhere, China has shown signs of stabilising and in Europe the president of the European Central Bank has committed to encouraging growth with uber-dovish policy announcements in July.
Looking at the world in another dimension, one of the increasingly popular studies since the credit crisis in 2008 has been behavioural finance. This looks at the cognitive and psychological effects on the economic decisions of investors, both institutions and individuals. The related field of behavioural economics studies how markets behave in different conditions, with investor behaviour leading to bubbles and crashes.
The various academic studies point to under and overreactions to events because of investor pessimism or overconfidence. Loss aversion is another factor and it is no surprise that most investment suitability checks which managers now insist on giving prospective charity clients do place a high degree of emphasis on trustees capacity to lose capital or not.
In light of these issues, I am reminded of a trustee meeting with a Roman Catholic order and the comments of a wise old priest. In the face of a rumoured market meltdown, we discussed selling investments and holding cash. The priest summed up saying that the Church had been in existence for over 2,000 years, it had experienced many disasters without panicking and will likely be around for a further millennium or more!
It is appreciated that not all charities may be blessed with the same heritage or circumstances. While mere mortal trustees can overreact to the short term noise in the markets, most charities exist in perpetuity and can take a very long term view.
There has always been a potential mismatch between a charity and those who govern it. Unless the intention is to spend out the capital in a set period, charities tend to exist over many generations and can accept risk to get a better return for future beneficiaries. Notwithstanding the trustee’s duty of care, they are likely to be on board for a limited period of time. There can be disparity of expectation between the institution and the trustees who are loath to allow any drop in capital while they are "on watch".
In simple terms, charities can afford to take higher investment risk to meet their long term objectives providing they have short term liquidity or income to match current beneficiaries or shortfalls as a result of economic or other disasters.
Appreciating risks
Therefore trustees should appreciate the risks that exist in the world and how this might affect their investments. They should not be drawn into taking knee-jerk decisions based on psychological behaviours. As most investors know, trying to time markets – selling at the top and buying at the bottom – rarely works and in most cases is a costly exercise.
Behavioural economics have shown that despite current geopolitical crises, the markets have a tendency to march ever higher. While valuations are currently looking stretched for most asset classes, being fully invested and riding through the storms tends to add value in the long term especially if trustees are able to compound some of the returns.
Putting this in context, despite the ongoing tension in the Middle East, Ukraine and another potential economic default in Argentina, markets have risen in the year to mid-July albeit modestly. It has paid to remain invested to date.
Should trustees be preparing for disaster? There remains a degree of uncertainty surrounding the economic outlook at present, be it as a result of ongoing geopolitical risks, opaque messaging from both US and UK central banks, the occasional weak data release out of Europe, or the potential threat of an overheating US. In spite of this, global data continues to support my central view that the recovery is both broad based and sustainable.
I also believe that policy will remain accommodative and future rate increases will be extremely gradual. The world’s largest economy is beginning to fire and this will certainly boost the global economy as a whole and, in particular, hopefully kick start a dawdling eurozone.
Potential risk
That said, with the US beginning to hit full throttle, a potential risk to the global growth outlook has become an overheating US economy. It was correct to remain broadly optimistic after the weather related weakness experienced in Q1, however the strong rebound has produced a new potential headwind, in the form of increasing inflation and the risk of policy makers spooking markets by moving too early.
At present, the short term outlook appears good, with US inflation simply moving back up to target and the Federal Reserve again declaring its commitment to dovish policy. However, trustees need to continue to monitor the situation for warning signs.
In Europe, although there has been occasional weak data release from a number of EU countries the overall picture remains positive. Mario Draghi has initiated new and supportive policies, however the feeling is that he can and will go further if required.
None of the signs that preceded the 2011 correction in Europe, such as widening credit spreads and a spike in credit default swap prices, are currently evident and trustees should therefore remain constructive on the outlook for Europe. As with the US, we need to monitor the situation closely and understand structural risks to this scenario.
The recent poor manufacturing data out of the UK is seen very much an anomaly. The overall outlook has looked positive of late and the key risk has been the question surrounding the path of interest rate increases, which thanks to the recent poor data release has most likely been pushed out to 2015.
Elsewhere, sentiment in Japan and China has improved recently, as pro-growth and reformist policies start to take effect. The hope that this time, particularly in Japan, the reforms will have lasting positive effects.
Sufficient liquidity
In summing up, there is no doubt we are living in uncertain times but the economic signals are not indicating a critical point to make dramatic changes to charity investment portfolios. By all means, trustees should be assessing the risks that are specific to their charities as part of good governance. Ensuring there is sufficient liquidity in reserve for the short term to meet current objectives is a better means of disaster planning and should balance the risk of remaining invested for a brighter future.
