Charity investments are, at present, stuck firmly in ironic mode. The worst-performing asset class is also the one that is gaining most in popularity. The FTSE All-Share Index (UK equities are still the destination of choice for charity investors) lost 7.3 per cent of its value in the year to the end of February. The bond market, by contrast, produced a positive return of 5.4 per cent. The heady days of 2012 and 2013 are definitely over and equities, UK equities in particular, are struggling. The overall positive return many charities have generated is down to alternative assets such as gilts, property and, in some cases, overseas equities.
But the strife that equities are experiencing has not dented their popularity - just the opposite, in fact. "In the last year or so we've seen a further rotation out of bond positions, and maybe some property positions and cash positions as well, into equities," says Richard Macey, director of charities with the fund management firm M&G Investments. "We've seen that direction of travel continue."
The reason, in Macey's words, is "sadly, an increasing thirst for income". As the sparsity of funds from central and local government persists and public fundraising remains beset by difficulties, charities want as much income from their investments as they can realistically amass.
Equities pay dividends, and UK equity dividends are usually higher than in other countries - on average 3.8 per cent, as a percentage of earnings, compared with 3 per cent globally. "We know investors are searching for yield," says Marc Hendriks, investment officer with Sandaire Investment Office, "so there is a demand for so-called income-yielding equity."
But the UK equity market is skewed by many poor-performing mining, oil and bank stocks, such as Rio Tinto and BP.
Low commodity and oil prices mean that many large companies can discern no light on the horizon and there are concerns about whether they can maintain their existing levels of dividend payments. Nonetheless, charities are still driven to invest for income and will stay loyal to the UK market, says Macey. "A lot of charities will stay predominantly in the UK," he says.
"It's a market they know well and in which the majority of their liabilities are based as well."
There is, however, increasing interest in overseas equities as a source of growth.
Japanese shares, for example, produced a total return, in sterling terms, of 15 per cent in 2015. Andy Pitt, head of charities in London with the investment firm Rathbones, warns charities not to be "fixated" by the search for high income. "We are a great advocate of making more use of overseas markets than perhaps some other firms," he says.
It is also true that overseas equities have become more attractive in the run-up to June's EU referendum, as the value of the pound erodes - it has dropped by more than 10 per cent since the start of the year. When returns are converted back into sterling, they receive a boost. The US stock market, the Dow Jones, grew by 1.3 per cent in the first quarter of 2016. In sterling terms, however, it was up by nearly 4 per cent. International equities are also considered inexpensive. "If you believe the world economy is growing - and we do, at about 3 per cent per annum - then companies exposed to that should at least protect you from inflation," says John Kelly, director of client investments with CCLA. "There's good value there." The downside of international equities is the weaker level of dividends. In both the US and Japan dividends stand at about 2 per cent, much lower than in the UK.
What about Brexit?
The possibility of Brexit in June muddies the waters immensely for charity investors. Brexit will probably generate severe market upheavals, at least in the short term. "At the moment I think the market is discounting (pricing in) a stay-in vote," says Kelly. "Assets are priced on that basis. If that were not the case, you would definitely see some very significant turmoil in investment markets. It might not be justified and it might not last, but prices would have to adjust very quickly."
But Brexit is also likely to damage small and medium-sized companies, currently the strong performers in the UK equity market, while leaving large companies, presently disappointing, relatively unscathed. Medium-sized companies usually sell in the home market and the EU, while large, UK-based companies have more global revenues. The so-called mid-caps are currently the beacon of light in the UK market, paying down debt and hitting or beating dividend targets. And some charity funds specialise in investing in them. Large companies, by contrast, are generally struggling. But Brexit could alter that. "The concern would be a bifurcation of performance," says Kelly. "The smaller ones are reassessed because their prospects are less strong than they would be."
Even the thought of Brexit materially changes the investment climate. The pound has palpably weakened, as it did in the lead-up to the Scottish referendum in 2014. This has both advantages and disadvantages for investments. Bonds and cash are detrimentally affected by higher inflation, which is likely to increase under a weak pound (inflation is currently at 0.5 per cent, which, though historically low, is the highest it has been since December 2014). Concern over Brexit and its actual occurrence are both likely to lead to overseas investors selling their government bond holdings because of uncertainty about the UK's economy. "Large-scale selling (of bonds) could push prices down, which would be unhelpful for most investors in the sector, including charities," says CCLA's Kelly.
Property, a staple of portfolio growth for many charities in recent years, has also been affected (see page 47). Mark Carney, governor of the Bank of England, and others, have noted a fall in the number of commercial property transactions as the vote approaches - this will affect returns. "If you have a portfolio of commercial properties - offices, industrial units, leisure facilities - that will have a knock-on effect," says Macey.
But there are indications that charities, faced with roller coaster markets, are becoming risk-averse. UK markets fell by 12 per cent in the first two months of 2016, which Kelly says represents some of the worst early returns he has seen. However, they have since recovered those losses. Kelly says many charities paused investments at the start of the year, while the market was in turmoil. The strong last quarter performance of bonds surprised many. But Macey says pension funds and other institutional investors sought out bonds as "safe havens to park funds while de-risking portfolios".
Market volatility could return for any number of reasons, such as Brexit, Donald Trump in the White House or renewed fears of global recession. These events might not happen - but then again they might. Hendriks believes the sharp contractions at the start of the year "did a lot of damage to market psychology". He predicts "higher than normal cash balances held by investors" despite negligible interest rates "because they simply just want to take profits off the table and hold on to gains". Charities are traditionally seen as long-term investors, but many are relying on short-term investment income as never before. The current state of the investment market presents a quandary. It offers charities the income they covet alongside the extreme volatility they want to avoid.