The latest Charity Market Monitor report, which outlines the finances of the top 500 UK charities, shows that their income from investments fell by 8.4 per cent, or £22.8m, between 2007/08 and 2008/09.
This is particularly worrying for the sector because statutory income is falling and other sources of income are, at best, uncertain. It is therefore regarded as more important than ever for charitable organisations to achieve higher returns on their investments.
To achieve this, some are turning their backs on traditional, solid portfolios in favour of more aggressive approaches, believing this is the answer to mounting financial pressures; others regard it as foolish short-termism. All agree it is an important development that should be watched carefully.
One of the most striking changes is the switch from cash to equities. To some extent this reflects a loss of faith in the safety of cash. The National Council for Voluntary Organisations estimates that UK charities lost £120m of cash reserves in the collapse of Icelandic banks. One of those affected - Naomi House children's hospice in Winchester, Hampshire - lost £5.7m, or 30 per cent of its reserves.
But a more likely reason is that cash no longer provides sufficient returns. Mark O'Connor, head of institutional business development at the charity investment specialists Ecclesiastical Investment Management, says: "Cash has gone from delivering an annual return of between 4 per cent and 5 per cent to offering only 0.5 per cent. Understandably, we are seeing investors who would not previously consider non-cash investments now looking at investment funds, especially equities and fixed-interest, in an attempt to improve their income levels."
Cash is not the only traditional charity investment no longer performing well. Chris Wyllie, chief investment officer at the private investment house Iveagh, says: "Charities used to go for safe investments such as gilts, but these now return only 3.5 per cent, which is a low nominal return and a negative real return. The only way to achieve the income charities need is to invest in equities - but this drives them up the risk curve."
Nevertheless, a number of charities are so disillusioned by the performance of their investments that they are prepared to take the risk. Some have been looking across the Atlantic at the returns made by US charities, which have traditionally made greater use of equity-based investments, and wondering if they could replicate their success.
But not everyone believes this is a wise move. Many US charities have begun to move towards more risk-averse strategies after becoming too dependent on equities a few years ago when the recession hit and finding themselves in need of more liquid investments, such as cash, to weather the economic storm.
Jeremy Hervey, head of charities at Cazenove Capital Management, says: "The major lessons learnt from charity investment in the US concern the liquidity difficulties faced in 2008 by some of the larger US charities. They found themselves unable to exit investments when markets started plummeting, and are now focused much more strongly on liquidity."
Mark Powell, senior investment manager for charities at the investment managers JM Finn & Co, urges charities to take a longer-term approach rather than chase short-term gains. "While quarterly or six-monthly return comparisons are certainly important, we place more emphasis on three-year returns because these smooth out shorter-term volatility," he says.
Powell also thinks expectations need managing. "Charities need to be realistic on income demands when interest rates are at 0.5 per cent, 10-year gilt yields are at 3.7 per cent and the FTSE 100 Index is yielding 3.2 per cent," he says.
"While we are comfortable constructing portfolios to meet an income requirement of 4 per cent or slightly higher, asking for much more than this will incur additional risk."
Many charities want to invest ethically as well as profitably. This is a challenge, but not impossible, according to Edward Kirwan, head of charity investment at the private banking firm Coutts & Co. He says investing in microfinance, which provides financial services to poorer people, is one way that this can be achieved. "Microfinance offers a proven way of delivering both a financial return and a social return because it helps to alleviate poverty," says Kirwan.
For organisations looking at more conventional vehicles for investment, Wyllie says many potentially profitable sources of income can be found by foraging around - offshore hedge funds are one example.
He adds: "It is possible to put together a portfolio that increases income without adding significantly to volatility." But his advice to charities considering this is to to do it "in a structured way, working with experts".