Be smart and diversify in 2007

Diversification, training and cash are the latest trends, says Tracey Reddings, executive director of the Charities Aid Foundation.

When it comes to investment, charities are traditionally a cautious lot. Although the cost of carrying out their missions grows ever more expensive, their budgets remain eye-wateringly tight. And with an erratic and unpredictable income from grants and donations, charities often find themselves in a state of perpetual financial uncertainty.

It's hardly surprising, then, that they have earned themselves a reputation for being risk-averse. But over the past decade a wind of change has been blowing. Charities have shown an increasing willingness to adopt a bolder and more confident approach to their investments. This can be attributed in part to the Trustees Act 2000, a key piece of legislation that has made charities take greater responsibility for their investment decisions. It has acted as a catalyst for trustees to take a more sophisticated approach as they seek the best financial returns on their charities' investments.

As a result, the sector is slowly waking up to the need to move away from long-held traditional views and invest in a range of investment classes in order to meet its fiduciary responsibilities. But it needs to accelerate this pace of change. Charities need to go further and move faster.

Reacting to market trends is not good enough. Charities need to be proactive and willing to challenge themselves and their investment strategies to make sure they are fit for purpose and fit to meet their future aspirations. By being too cautious, charities also expose themselves to greater risk through insufficient diversification.

Let me clarify what I mean by diversification. Many charities assume that putting their eggs in different baskets - that is, in different asset classes - is sufficient. Thus a fairly cautious asset mix for a charity might lead it to invest 50 per cent of its liquid assets in equities. But what if that 50 per cent was all invested in FTSE 100 equities? Pinning the hopes of half of your charity's liquid assets on the performance of 100 UK companies is hardly diversification. A more balanced holding might include other UK and overseas equities. So it's not enough to diversify across different asset classes; you also need to diversify within those asset classes.

Interestingly, David Rowe, head of the charities team at wealth management firm UBS, reports seeing a move away from UK to overseas investments as well as an increasing use of alternative asset classes. He doesn't believe this represents a headlong rush - more the continuation of a process of investing in assets that are not closely correlated.

New finance directors are apparently growing keener to embrace greater use of alternative asset classes, including property, private equity and hedge funds. But a word of warning: the rule of diversifying within an asset class applies equally to the alternative as it does to the core asset classes. So investing 10 per cent of your charity's funds in a single property is far riskier than 10 per cent invested in a property fund that spreads its risk across a portfolio of hundreds of properties.

Diversifying your holdings can make your charity's assets more complicated to manage and certainly requires more informed decision-making. And there's no doubt that many trustees owe it to the charities they oversee to improve their skills and keep abreast of trends and developments. Blindly following everyone else and jumping onto bandwagons just as the wheels are about to fall off is clearly not a sound investment strategy.

Rowe believes that one of the best ways for trustees to increase their knowledge is to have professionally run training, topping up their knowledge periodically by attending seminars and referring to publications. As trustees change, Rowe thinks there will be an increased appetite for training.

This demand has led to the creation of courses such as the Foundation and Endowment Asset Management programme at the London Business School - a five-day course that helps charities develop skills in managing their investment assets and making more informed investment decisions.

Being well-informed can help trustees to challenge investment managers and advisers more effectively, thus ensuring that any decisions are robust and meet their core financial objectives.

This move towards learning is another trend I'd identify for 2007 and beyond. Charities are seeking professional advice in greater numbers. I believe there are two reasons for this: first, a tougher fundraising environment is leading charities to place more emphasis on investment income; second, assumptions about future returns cannot be based on past performance, as endowed charities know to their cost.

Given their history of trepidation, it comes as no surprise that cash is king for charities. A joint Ethical Investment Research Services and Charities Aid Foundation study in 2003 revealed that 57 top charities and foundations held 27 per cent of their liquid assets in cash deposits. Of all the asset classes, cash is the lowest risk, has the ultimate liquidity and can always be called upon to meet immediate or medium-term shortfalls in funding. Moreover, the interest rate rises of the past 12 months are fuelling the 'dash for cash' as it begins to look increasingly attractive.

Paul Palmer, professor of voluntary sector management at Cass Business School, agrees. He believes charities need to strike a balance between funding the needs of the present and those of the future. Equities are historically the best- performing asset class over the longer term, but they are not right for immediate and medium-term expenditure.

Palmer believes cash products, particularly the fixed-rate types, are ideal for charities. But he also believes too many charities leave far too much of their cash in high-street current accounts, earning a negligible rate of interest. He does not advocate that charities invest 100 per cent in any single asset class, of course, but he does recommend a focused asset allocation that includes cash products.

Cash may be superficially attractive for its low-risk profile and liquidity, but if it sits idle for too long, inflation soon eats into its buying power. Palmer believes good cash-flow management and a more proactive style, given that cash is not always needed when expected, could result in charities using this asset better.

The trends towards diversification, advice and cash are not the only ones to emerge in the past 10 years. Mission-related investment is a relatively new phenomenon, but is rapidly gathering pace. It's about aligning a charity's financial objectives with its mission. In practice, this means socially responsible investment, or SRI. This is booming. Twenty years ago, the UK's first ethical investment fund was launched. Today, ethical investments are worth more than £6bn in the UK.

However, charities' willingness to adopt SRI has not been strong. Sam Collin, charity adviser at Eiris, says there may be a fear among trustees that they will get a lower financial return on SRI. But there is no evidence for this. Nine out of 10 ethical funds performed better than the FTSE All Share Index in 2006, and three-quarters reached the top quartile of the unit trust league tables.

The king of the SRI jungle is the Friends Provident Stewardship range, managed by F&C Asset Management Group. Its funds under management now top £3bn, and its Stewardship Income Fund is in the Principal White List of consistent performers in the income sector for the fifth year running.

But SRI is only one of a number of competing demands on charities' investment strategies. Charities need to be diversified across and within a range of asset classes. They need cash to stay responsive to their immediate needs and they should give due consideration to including a socially responsible element where it aligns with the charity's objectives.

Above all, I believe they need to get smart, take calculated risks, seek advice and be realistic in their planning. And they need to do all of this against a backdrop of falling investment returns.

The early signs are hopeful, but charities will need to raise their game considerably if they are to meet the challenges of a fast-changing investment landscape.

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