Andrew Wauchope: Are charities taking on too much investment risk?

With interest rates at historic lows, charities need to seek a wider range of asset classes to deliver returns, writes the senior investment director at Psigma Investment Management

Andrew Wauchope
Andrew Wauchope

While corporate credit has replaced some of the previous exposure to sovereign bonds, there have been good reasons for charities to increase their exposure to equities. If we cast our minds back to November 2008, the price/earnings ratio for the UK market was in single figures (9.39), while worldwide markets reflected similarly distressed levels.

As central banks pumped liquidity into the system, the attraction of these low valuations and the impact of liquidity on earnings provided a strong case for investment. Those who had the courage to invest have seen very attractive returns. For an investor who waited until the end of March 2009 to invest, the MSCI World Index has returned 181.69 per cent in Sterling terms to the end of July.

The US market was even better for a Sterling investor – over the same period, returning 243.46 per cent. Even without the benefit of currency translation, the UK FTSE 100 returned 123.89 per cent. However, it would be a brave, or foolhardy, investment manager who would predict similar returns over the next five years.

The market environment is now even more challenging. If it wasn’t just that global growth was slow, political risks were high and inflation uncertainty raised, central bankers are destroying any valuation anchor for financial markets with the manipulation of interest rates to zero and the deluge of stimulus programmes makes the job of an asset allocator even harder.

Markets are also at historically high valuations. The UK market is on a PE ratio of more than 17.1 and the US market on 18.4. Therefore, equity markets offer pretty poor value from today’s starting valuations and, although high valuations and poor growth potential may not actually prove obstacles to markets becoming more expensive in the short term, it should at the very least prompt some further serious thought.

Investors are reviewing their return expectations for equities from these levels. For example, our current forecast is 4.8 per cent per annum return for the next five years for developed world equity markets. This compares with forecast before the Brexit vote of 6.6 per cent.

Equity investors are therefore holding an asset class which is at the top end of its valuation range and with a low rate of expected of return. Consequently, charities need to revisit their asset allocations to ensure the return characteristics of their portfolios are consistent with their aims and that they are not taking on unnecessary risk for lower returns.

The logical step is to reduce the dependence on equity in portfolios and seek a wider range of asset classes to deliver returns. The advantage of a broadly diversified portfolio is that it not only gives a portfolio a wide source of returns but also ensures the assets in the portfolio are not closely correlated.

The importance of this is that the assets are then unlikely to react in the same way to changes in economic circumstances.

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