In pursuit of the perfect investment portfolio

The perfect portfolio seems as elusive as the Holy Grail, but there's a lot that charities can do to make sure their investments do what they want them to do, as Emily Ford discovers.

For charities trying to navigate the investment minefield, the frustrating truth is that there is no such thing as the perfect portfolio - it depends entirely on what you want to achieve. What is the time horizon involved? Will you need the money in three years or can you leave it to accumulate for 10 years? How much income do you need to draw? And how much risk are you prepared to take, and for what return?

A large chunk of the sector 'warehouses' money, keeping it in cash deposits or near-cash funds in case they need to access it, says James Bevan, chief investment officer at social investment fund CCLA. If retaining cash is a priority, don't be persuaded to tie your money up elsewhere, hoping for a quick return. "Charities need to avoid the temptation of jumping on the bus that is travelling fast," Bevan says.

Other charities have a fixed time horizon with funds to be spent over a period - on a current project, for example. These charities can do better than cash, but cannot take risks on the open market. "While this group can invest in a broader range of asset classes than cash, they need to have certainty of payout at the end," Bevan says. The rest simply want to invest surplus funds, have no fixed time horizon for getting their money back and are prepared to accept fluctuations in value along the way.

Before deciding to invest, charities need to draw up a clear reserves policy, stating what they can put away and for how long, and establishing a reasonable expected return. A portfolio should be underpinned by an investment policy stating your time horizon, desired return, acceptable risk levels and any assets to exclude; Charity Commission guidance says these decisions should be made with beneficiaries in mind. Many charities neglect this stage, says Mark Morford, product manager for investments at the Charities Aid Foundation. "When we see organisations, they often haven't thought thoroughly about what they want before they start to engage with investment managers," he says. "There's an awful lot of preparation work I would recommend any charity goes through before it starts to look at types of investment."

The longer you put money away for, the better your return is likely to be. "A lot of charities don't commit money long-term when they could do so very easily," says Andrew Pitt, head of charities at the bank UBS, which manages £1.5bn in investments from about 400 charities. The more diversified your assets, the less vulnerable you are to the particular performance of one type; the more varied the types of investments and the more widely they are spread - having deposits with different banks, for example - the less risk the portfolio carries. "Financial markets have been very volatile over the past few years," says Pitt. "We would recommend investing in a spread of assets to avoid the volatility observed by some trustees."

Charities tend to rely extensively on cash deposits, which do not give the best return, and on property. Government bonds are seen as secure, although in any 20-year period in the 20th century, equities (shares) outperformed them. "If you hold equities they go up in value eventually because you are holding stakes in real businesses, and a well-run real business should grow over time," says Charles Nall, corporate services director at the Children's Society and chair of the Charity Finance Directors' Group. Equities in an index-tracker fund are a sensible option, typically giving between 5 and 10 per cent in capital growth as well as paying dividends, and absolute return funds promise a certain percentage return regardless of whether the market is up or down. The Children's Society holds these. "They don't do as well when the market soars, but they do avoid the worst of the falls," Nall says. It is best to steer clear of derivatives, or leveraged products: they magnify the returns in good times, but also the losses in bad times.

Alternative assets

Pitt of UBS says his clients are beginning to explore 'alternative' asset classes that make money while still keeping risk to acceptable levels. The most controversial are hedge funds - although these cover a huge variety of different strategies. "We consider hedge funds to be less risky than equities," he says. "Certainly, some hedge funds are high-risk, but 'funds of funds' - mutual funds that invest in other mutual funds - are relatively low-risk."

Private equity - investing in private companies as opposed to those publicly listed on a stock market - can bring substantial returns, but tends to require investments of 10 years or more. "By holding out for a higher return, you've got to give up liquidity," Pitt says. He recommends putting no more than 5 to 10 per cent of a portfolio into private equity and never more than about 20 per cent into hedge funds. Commercial property is growing in popularity, as is infrastructure - investing in building projects such as schools, roads and hospitals.

Whichever assets you choose, consider a mix that will achieve your overall aim. "The danger is that organisations look to overachieve their requirements and expose themselves to volatility and risk that they are not comfortable with," says Morford of CAF. "Blend assets to meet your aim, as opposed to creating a portfolio to build the best possible return."

Most large charities hand over the management of their portfolios to professional fund managers.

But if a manager is not appropriately skilled in charities, there is the danger of inappropriate investments being made that are not allowed by the Charity Commission - such as purchasing a piece of art in the hope that it will increase in value.

Few charities can afford to employ investment managers directly, but many recruit former City professionals to sit on investment committees. "Trustees ultimately have the responsibility to their stakeholders to set their strategy, monitor performance and replace fund managers if they are not doing their jobs," Nall says.

Most charities work to a three-year investment cycle. As rule of thumb, charities should review their portfolios quarterly and meet the managers at least once a year; many hold 'beauty parades' to which other fund managers are invited. "To micromanage will serve no purpose - fund managers are going to vary in performance from month to month," Morford says. If there is a dip in the value, a good manager will be able to explain it. "No one fund manager has consistently outperformed his asset class," says Morford. "The question is, are they just going through a bad patch or is there a more fundamental reason?"

Informed decisions

Common sense - and the commission - dictates that investments should not interfere with a charity's mission. Charities need to be clear about what they won't invest in, because exceptions can quickly become complex. For example, the 4 per cent of the London Stock Exchange made up by tobacco is dominated by Imperial Tobacco and British American Tobacco, but there are about 25 other companies involved, from Tesco, which sells tobacco, to Filtrona, which makes cigarette filters.

"You've got to be pragmatic," Pitt says. Charities used to spurn companies in ethically dubious fields, but now the focus is on engagement. The Children's Society refuses to invest in landmines or pornography because they "damage human beings and the dignity of human beings". But in other controversial areas the charity invests so that it can begin a dialogue about issues such as the marketing of alcohol to young people.

Gambling with donations can itself seem ethically dubious, but the likelihood is that investing will maximise your funds, providing you make informed decisions and hold your nerve. "Many charities have infinite time horizons, which means they can hang on until investments go up," says Bevan. "I'm a firm believer that everything ultimately goes back to a long-term average, despite the noise along the way."

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